Every so often, Indian investors take a fancy to an investment idea that’s a hit in the US markets and make a beeline for it believing that it will work equally well here. One such idea that has gained ground in this bull market, is a passive income strategy focusing on stocks.

Many investors today ask if they should regularly plough their savings into SIPs in a Coal India, REC or ITC over the next 10 or 15 years, so that the dividend income from these shares can help them retire early. But setting up a steady income stream from stocks for the long term isn’t easy. Here are some pitfalls to watch out for, if you’ve been toying with this idea.

Dividend may be one-off

A screener for dividend yield stocks today throws up many names with 9-10 per cent dividend yield. This may lead you to believe that all you need to do for a passive income portfolio is to identify a few such stocks and plough your savings into them. After all, at a 10 per cent dividend yield, a ₹50-lakh portfolio can fetch you a cool ₹5 lakh in dividends every year. But in reality, double-digit dividend yields are rarely sustainable.

Many Indian companies declare special dividends to mark events such as anniversaries or to distribute cash from the sale of a business or brand. Many of the double-digit dividend yield stocks you see on your screener fall in this category where one-off dividends have lifted the yield.

A recent example of this is the Hinduja Global stock (trading at ₹1,100 levels) with a current dividend yield upwards of 15 per cent. Normally not a generous dividend payer, with annual payouts of ₹25-40 per share, the company distributed ₹195 per share as dividend in FY22, after it received a windfall from selling its healthcare services division to Barings Equity (shareholders expected much higher dividends which didn’t materialise). When companies pay special dividends out of proceeds of a business sale, the loss of revenue could dent future earnings as well as dividend payouts. When assessing dividend yield, be sure to leave out one-off components to arrive at the sustainable payout.

Earnings may be volatile

A big assumption you make when buying a dividend stock for income needs, is that the current level of dividends will be sustained over the long term. This assumption is questionable if the company’s earnings are subject to volatile swings from year to year. With a double-digit yield, the stock of multinational specialty chemicals-maker Clariant Chemicals featured prominently on the list of big dividend payers last year, after declaring dividends of ₹140 per share in FY20 when the stock traded at ₹480. But assessing the company’s earnings over a 10-year period suggests that it witnesses significant earning swings from year to year that result in widely varying dividend payouts. Clariant’s earnings per share have swung between ₹8 and ₹95 in the last decade, while its dividend payouts have fluctuated between 50 and 240 per cent. Definitely not the kind of stock you’d rely on for steady income.

In India, many high dividend yield stocks hail from cyclical sectors such as oil, steel, metals and mining, where profits can soar manifold during boom times in the commodity cycle and dwindle equally fast when the cycle abates. In cyclical stocks, you need to assess earnings and dividend payouts at the bottom of a cycle to know the long-term dividend potential.

Uncertain future

When a bull market has been in progress for some years, stocks that continue to trade at low valuations are often those where the market thinks the governance is problematic or the business has an uncertain future. High dividend yield stocks are often just low PE stocks. So betting on them can leave you open to sharp erosion of capital, if earnings or governance issues crop up.

With consistent dividend yields of 8-9 per cent, government-backed power financiers REC and PFC have always appeared to be good choices for income-seeking investors. But with perpetually stressed State discoms as their major customers, the two NBFCs are persistently dogged by asset quality worries, making fundamental investors wary of taking long-term exposures to them. Generous dividends of ₹10-13 per share in FY21 did not prevent the PFC share from plunging from ₹150 to ₹115 levels or REC from ₹165 to ₹126, in the correction over the last six months. Consistently high dividend yields on ITC or Coal India are also a function of the markets worrying about an uncertain future for the tobacco and coal mining businesses respectively.

Strategy notes
Double-digit dividend yields are rarely sustainable
Compute yield by leaving out one-off components
Assess long-term dividend potential of cyclical stocks
Key takeaways

In light of the above, there are three key takeaways for Indian investors seeking passive income.

The Indian stock market is structurally a low dividend yield market, with average dividend yields on the Nifty500 at 1-2 per cent. At a 2 per cent dividend yield, a portfolio size of ₹2.5 crore would be needed to yield just ₹5 lakh in annual income. If a company’s dividend yield is many times this average, it usually indicates higher business risks. This calls for more due diligence on a company’s financials and business prospects when you select high-yield stocks.

Companies in growing businesses with a moderate dividend yield are usually better for a long-term passive income portfolio than high dividend yield bets.

In India, unlike the US, yields on safe fixed income investments are consistently much higher than earnings or dividend yields on equities. Today, after the rise in rates, 40-year government bonds that offer sovereign safety offer a post-tax yield of about 5 per cent even at the highest slab, while the Nifty 500 dividend yield is 1.2 per cent. Therefore, your passive income portfolio should prioritise debt over equities. If you get to lock into long-term government securities or high-quality bonds when rates are high, they can generate passive income with greater certainty and capital safety than equities.