The Art of Dividend Investing

In this issue:

» Will the Fortunes of E-commerce Firms Improve?

» LIC Funds PSU Banks!

» ...and more!

This is one of my favourite topics: Dividend Investing. It probably makes me a bit of a misfit in the analyst community. Analysts love to talk about growth.

We talk about growth in volumes, growth in sales, growth in capacity, growth in profits, growth in earnings... even 'growth in the share price'.

There are two ways to make money in stocks: the popular way - capital gains (i.e. growth) and the not so popular way - dividends (i.e. income).

We tend to get obsessed with capital gains. This is understandable. Who doesn't like capital gains? The more the better! But chasing growth comes with its share of risks.

The problem with growth stocks is simple. The market loves them. Everyone knows about them. So these stocks never trade cheap. The more expensive they get, the higher the risk of a big crash if something goes wrong. You should always have a clear idea about when to sell growth stocks. And you should actually execute the sale before the party ends.

Dividend investing is different.

Dividend investors don't seek growth. Of course, they'll take it if they can get it. But they don't actively look for it.

What do they look for?

Stability.

Investing in a stable dividend-paying company can let you sleep peacefully at night. The business will generate a steady passive income. The more stable the business, the higher the share of profits that can be distributed.

All else being equal, a company with a higher dividend payout is more stable that a similarly sized competitor with a lower dividend payout. Of course, I've simplified things a bit here. But the basic logic is solid.

But that does not mean you should jump into stocks with the highest dividend payout ratio. If a company pays out all its profits as dividends, it may not always be a good sign. It could imply that there's no chance of investing the profits back into the business at a decent return.

This is why it's better to look for a company with plenty of room to increase the dividend payout in the future. Remember that dividend investing is all about stability. Investors don't like it if the per-share dividend is reduced just because profits are down in a given year. But this is exactly what can happen to a company that is paying out all its profits.

So does this mean that you should only consider stocks with low dividend payout ratios and hope that the payout will increase?

No.

This is as much a science as it is an art. Many questions have to be answered.

How stable is the business model? How strong are the cash flows? What are the prospects for the industry? What is the company's position in the its industry? How good is the management? What are the debt levels? And yes, how fast can the earnings grow?

The answers to these questions will determine the price to buy the stock and how long you should hold it. Finding answers to these questions can be exciting. But these questions will excite only long-term investors.

Buying a stock for 'growth' - i.e. capital gains - can be more rewarding in the short-term. But the risks are higher too. Many investors are not comfortable with that risk. Many prefer companies that pay dividends that can grow at a steady rate every year.

Dividends are not just a source of income. They provide stability to your portfolio and can even offer higher returns in the long-term. There is a large body of academic research in the US that proves long-term returns from dividend stocks are higher than non-dividend stocks. I wouldn't be surprised if similar studies in India came to the same conclusion.

If the idea of buying stocks that let you sleep soundly at night interests you, we have good news. We have just released a special report, Steady Income Smallcaps III. This report contains three stock recommendations. These stocks offer not just high dividends but also good growth potential. They are ideal candidates for long-term investors.

You can gain access to this special report here.

02:35 Chart of the Day

The festive season has started.  With host of ecommerce companies laying full page ads and coming up with TV commercials to lure you with limited time period and discount offers, there is no way you can miss its arrival.

There is hardly someone with access to internet who would not have experienced online shopping yet. It's indeed a megatrend getting bigger with the time. In the battle within the ecommerce titans - Amazon, Flipkart and Snapdeal, it is the consumer that is emerging the winner.

E-commerce Firms Gearing Up for Next Round of Funding

So where are these firms trying to get with claims of doing the highest sales?

Well, it seems they are gearing up for next round for funding. With an unclear business model and bottomline still in red, the only argument that they have to make to be the best and deserving is their sales and market share.

As an article in Livemint suggests, Flipkart, after generating bumper sales during Big Billion Days (BBD) sale this month, is planning to raise large round of funds from fresh investors. It is looking to raise at least US$ 500 m and could go up to US$ 1 bn.

One must note that after multiple rounds of such fund raising in the preceding years, the e- commerce firms had hit a valuation wall early this year. Their valuations were slashed by more than a quarter and were getting a cold shoulder from investors. With the rise in competition in the online market place and ballooning losses, investors were forced to change their mind about the huge 'start up' opportunity.

Now that the Finance Ministry is considering removing multiple restrictions on ecommerce, these firms might be able to talk investors into funding them. And the shopping fest may continue for consumers. So far, so good.

But the issue one needs to ponder is... Where and how will this end? The big investors who are pouring funds in these cash burning business models are not doing so out of generosity. They hope to make good returns at last, whenever they decide to exit. And this is where all this have serious implications for common investor.

One of the ways to exit will be IPOs for these firms. The way it is raining IPOs, even for loss making businesses, the day may not be too far.

And while you can relish this megatrend as a consumer, investing in these firms will be a whole new ball game. And not a good experience we believe. The reason is these businesses are far from being profitable. And without profits, the ecommerce business model cannot be a long-term success. Their key argument so far has been gross merchandise value, which is a function of discounts, and can only work against profitability.  So while you must continue to ride on this boom as a consumer, beware of being a stakeholder in these firms as a shareholder.

The fact that public sector banks (PSBs) are facing issues of deteriorating asset quality is well known. In such situations, it becomes important for banks to shore up their capital so that they can instil some trust and better withstand any crisis.

So who is helping these PSBs raise money? It is none other than Life Insurance Corporation of India (LIC). As reported in the Business Standard, the country's largest insurer, which invested nearly Rs 30 billion in state-owned banks in the last financial year, is taking part in preference share issuances by banks in the current year as well.

All of this seems to be part of the government's announcement of Rs 700 billion capital infusion for 22 public sector banks by March 2019.

LIC has become quite notorious in not doing a great job while managing public money. Vivek Kaul, has covered this topic in his Diary. He writes:

• LIC is doing a terrible job of managing public money. Any investment firm should be able to generate average returns greater than the returns on government bonds, at least. It should also be able to beat the inflation. In fact, that is what it is paid a fee for. But that doesn't seem to be happening in case of LIC. The investment returns of LIC have been consistently lower than the 10-year government bond returns.

He further adds...

• LIC now owns 21.22% of Corporation Bank, 14.37% of IDBI Bank and 14.99% of Dena Bank. Again, the question, why should an investment firm managing public money be taking on such concentrated risk? In fact, the Securities and Exchange Board of India(Sebi) regulations do not allow a mutual fund to own more than 10% of a company.
  
  Why doesn't the same rule apply to LIC as well? Like mutual funds LIC is also in the business of managing hard-earned public money.

LIC has been the single-largest buyer of government bonds over past two years. By acting as a saviour for the government, the PSU insurer is clearly putting the interest of its investors and policy holders at risk.

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The performance of global markets this week was a mixed bag. Among the key global markets, US stock market witnessed losses (down 0.4%) for the week. The US market went into the correction mode, following a jobs report that came below expectations.  Yet the data was viewed to be strong enough, boosting the chances for rate hike in December by the US Federal Reserve.

European stocks were lower as investors remained cautious ahead of US jobs report and plunge in British currency. British Pound crashed to 31-year low in a flash crash, and fell by more than 6% against US dollar on Friday. Markets are increasingly worried over heated discussions surrounding UK's exit from EU.  British Prime Minister Theresa May announced to initiate the process of Britain's exit by end of March 2017, marking the start of a two-year exit process.

Back home, after the last week's plunge, owing to surgical attacks in terrorist camps in Pakistan, the markets closed in green up 0.7% for the week gone by. On the back of inflation data and the slowing growth rate, the Reserve Bank of India (RBI) announced cut in the repo rate by 0.25 per cent on Tuesday. However, the Cash Reserve Ratio (CRR) was kept unchanged. The repo rate stands at 6.25 per cent now.

On the sectoral indices front, stocks from oil and gas sector witnessed was the leading gainer in the pack. The oil and gas index hit eight year highs and was among the best performer. The worst performer for the week was IT index, down 1.4%.

04:55 Weekend investment mantra

"Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Richa Agarwal (Research Analyst).