Dividend-yield delivers

Investing in stocks with high dividend yields has been a winning strategy in the developed markets. Among the many strategies, ‘Dogs of the Dow,' which involves selecting the highest dividend yield stocks from the Dow Jones Industrial Average, has gained popularity among investors, given its consistent out-performance of the index.

But will such a model work in India, where dividends don't add all that much to stock price returns? (The bellwether index, Nifty has, after all, recorded an average dividend yield of 1.2 per cent over the last five-year period.) The answer, surprisingly, is that it does.

Back-testing a strategy of investing in high-yielding stocks from the CNX-100 index over the past five years shows that the ‘dogs of CNX-100' (the ten highest yielding stocks from CNX-100) out-performed the index in four of the past five years. For the year ended September 2007, however, the dogs of CNX-100 weren't a match for broader index returns (see Table).

In evaluating returns, we considered total returns including stock price gains as well as dividend yield. Dividend yield is calculated as a ratio of total dividend paid out by the company over the last year to the price of the share each September. In selecting stocks, historical dividends we considered, while for calculating total return dividend payout during the relevant period was taken into account (see Box story).

Five-year test

How did the portfolio fare over the five-year period? Back-testing a dividend yield portfolio since September 2006 shows that the strategy didn't work in 2006-07, but delivered great results thereafter.

The dividend dogs bought in September 2007 fell much less than the underlying CNX-100 index during steep market corrections. This was partly due to higher dividend payouts. Even as the portfolio lost 15 per cent, the average dividend receipt of these stocks, at 4.5 per cent of the initial price, limited the losses.

In the year ended September 2008, the CNX-100 index lost 23 per cent of its value, but oil majors such as HPCL, BPCL, ONGC and defensives such as Hindustan Unilever protected the downside for this portfolio.

During the next two years ended September 2010, the dividend dogs' returns were far superior, given the out-performance of mid-cap banks, thanks to bottom-fishing by investors. Beaten-down stocks such as Tata Steel and Tata Motors, which were dividend dogs in 2009 and 2008 respectively, also out-performed the market over the next year. In the latest year ended September 2011, the dividend dogs fell less than the broad market index in spite of sharp corrections in the financial sector. ACC, Hindustan Unilever and Colgate Palmolive helped protect the downside of the portfolio. The dividend yield of 3.6 per cent also did its part in limiting the losses.

Will the strategy work in the future?

The dogs' portfolio also matched / outstripped returns of actively-managed diversified equity funds over one-, two, three- and five-year periods. The data is back-tested and the results of the current portfolio may only show results next year.

However, Business Line's studies on the BSE-100 index prior to January 2006 also endorse the fact that the high dividend yield stocks outperformed the under-lying index in eight of the nine years ended December 2005.

Risks of the strategy

Taxes : Critics claim that tax on dividends in markets makes a dividend yield focussed strategy a suboptimal choice for investors in global markets.

This threat is somewhat mitigated as the dividends are not taxed in the hands of investors in India. Additionally, withholdings of over a year in equities exempt from capital gains tax in India, any holding period with a day more than a year would protect investors from subjecting their portfolio to capital gains tax.

Churn : A dividend yield strategy requires the investor to re-balance his portfolio every year. That is, he needs to sell last year's dogs' to replace them with this year's candidates. This re-balancing has been a difficult exercise, with more than four stocks moving out of the ten-stock portfolio every year. This involves transaction costs, which may marginally diminish the portfolio returns.

Skipped dividends : There is the possibility that a company chosen for its dividend yield will suddenly skip dividends the following year. For instance, the September 2008 choices — Wockhardt and CPCL — did not pay dividends in 2009, reducing the overall portfolio's dividend yield.

The portfolio today

Given that the dividend yield strategy has worked well for much of the last 15 years, what stocks would make it to the portfolio today?

We have constructed a ‘dividend dogs portfolio' with stocks from the CNX-100 as of September 30, 2011. Of the top dividend yielding stocks on the CNX-100, Patni Computers and Hero Motor Corp were excluded, as their recent dividends may not be sustainable, given the “special dividend” payout.

Having done this and stayed with the remaining top dividend payers, we find that seven stocks in the current portfolio are from the banking and non-banking finance sector. The portfolio includes large-cap names such as ONGC, Power Finance Corp, Union Bank, HPCL and IDBI Bank. Mid-cap stocks in the list include Ashok Leyland, Andhra Bank, IOB, Syndicate Bank, IFCI.

The portfolio is concentrated, with exposure to only three sectors. As we expect the prospects of financial companies to improve with expectation of interest rates at near peak, we have not introduced any subjectivity to reduce the sector concentration in the current portfolio.

However, we remain cautious on oil marketing companies, which have historically made it to the dividend yield portfolio quite regularly but have often turned laggards the following year.

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