By P Saravanan
Rising recession fears, concerns around the global economy’s growth outlook have led investors to search for ways to defend their portfolios. Investors with long-term horizons and relatively low appetite for risk may want to consider dividend-paying stocks, which offer shareholders regular payments as a part of profits.
With the appropriate mix of shares, dividends can provide cumulative growth by reinvesting back into the portfolio or can be used to buy additional dividend-paying shares, an empirically proven investing methodology that becomes even more favourable amid economic uncertainty.
Dividends and their types
Dividends are nothing but distribution of profits to the shareholders. Generally, dividend is paid in between two balance sheet dates. Sometimes a company may also choose to pay additional dividend in between two balance sheets, which is known as an interim dividend.
Dividends can be paid even if a company does not make a profit in that year but wants to maintain its record of making regular payments to shareholders. In this case, dividend is paid out of the reserves and surplus. Apart from the regular or final dividend, sometimes companies pay special dividends on attaining certain milestones. These are usually a one-time occurrence.
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Relying on dividend paying stocks
Good and consistent dividend paying companies have been sought after by investors across the globe. A study by Dimson and his co-authors found that a market oriented portfolio that included reinvested dividends would have generated 85 times the wealth generated by the same portfolio depending purely on the capital gains.
Of course, this wealth accumulation would have been lower if the dividends were not assumed to have been reinvested. One could argue that such returns are achieved by assuming a higher risk. But, quite contrary to this, it has been observed that good dividend yield stocks display less volatility.
The rationale for lower volatility is that these stocks with high and sustainable dividend yield are more resistant to a decline in price than that of lower-yielding stocks as these stocks are ‘yield-supported’. In other words, once the price of a higher yielding stock falls, the dividend yield rises again and this makes the stock attractive and helps in pulling up the price.
How to create a high dividend yield portfolio?
Diversify your holdings across good companies. Receiving dividends should be the main focus, not just growth. It is a good idea to diversify your holdings to include five to seven industries. Dividend stability and growth is the main priority, so you’ll want to avoid a dividend cut. If your dividends do get cut, make sure it’s not an industry-wide problem that hits all your holdings once in a while. Choose financial stability over growth.
Having both is best, but if in doubt, having more financial wherewithal is better than having more growth in your portfolio. Find companies with modest to good pay-out ratios. This is dividend as a percentage of earnings. Generally, a pay-out ratio of 60% or less is considered best as it allows for wiggle room in case of unforeseen company trouble. Find companies with a long history of raising their dividends.
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Companies that raise their dividends steadily over time tend to continue doing so in the future, assuming the business continues to be healthy. If you start investing for income well in advance of when you need the money, reinvest the dividends. While reinvesting, investors should carefully choose the stock with the similar risk with that of their existing portfolio else the portfolio risk will change. Dividend reinvestment can add a surprising amount of growth to your portfolio with minimal effort.
To conclude, investors tend to focus more on the capital appreciation component thinking that dividends are miniscule compared to the capital appreciation which may not always be true. Investors must look at creating a high dividend yield stock portfolio after considering the above aspects.
The writer is a professor of finance & accounting at IIM Tiruchirappalli