A Choice That Matters

Why do we invest in equities? Of course, for capital returns. ETIG's Krishna Kant demystifies this most commonly held logic behind buying into shares

Talk of equity investments and the first thought that crosses our mind is the capital return. "How much has your initial investment grown by now…" is the common topic of discussion among equity investors. Hardly anybody looks for the potential income stream that an equity portfolio can provide. But isn't this surprising because, by investing in the shares of a company an investor becomes part owner of a business enterprise. And any business by its nature generates profits and cash flows. As the economy grows, so does a company's business and the resulting profits and cash flows. And the companies, specially the well managed ones, share a significant part of their profits with shareholders in the form of dividends. 
    Though there's no thumb rule about the dividend distribution, companies in India typically distribute anywhere between 25-30% of their net profit as dividends to their shareholders. In FY08, for instance India Inc distributed nearly Rs 58,500 crore as dividends to its shareholders. During the three-year ending FY08, the dividend pay-out by India Inc grew at a compounded annual growth rate (CAGR) of 18%. At this rate, an investor's dividend income will quadruple in about 9 years. 
    So why not invest in a way so as to maximise this income stream (dividends) over a period of time, rather than chase capital returns. Anyway capital return is largely a function of timing—buy low and sell just before 
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tumble. This is difficult or downright impossible for a typical retail investor given their limited information and experience. Moreover, it requires constant monitoring of the market movements besides keeping a tab on the news flows. This is not everybody's cup of tea. 
    Critics of this strategy however say that Indian companies are so stingy with dividends that the cash flow will remain miniscule even in the longer term. We decided to check this out. We made a portfolio of 20 leading stocks from various sectors, equally divided between cyclical or growth sectors such as capital goods, construction, cement and metals and defensive sectors such as FMCG, 
healthcare and IT services. Some of the stocks in our portfolio include ACC, BHEL, BOSCH, Cipla, Dabur, Grasim, Hindustan Unilever, HDFC, ITC, GSK Pharma, Indian Hotels, Infosys, L&T, Nestle, Reliance Industries, State Bank of India, Tata Steel and Tata Tea among others. (See Pick the Right Mix) 
    Now imagine an investor who had made a staggered investment of Rs 10,000 each in these 20 stocks during year ending March 2003. Based on the historical dividend paying record of the respective companies, the portfolio would have provided the investor with a total dividend income of nearly Rs 5,750 at end of FY03. This looks a measly amount given the initial investment of Rs 2 lakh. But what makes this strategy worthwhile is the year-onyear upside in the income stream. By the end of the seventh year i.e. FY09, the investor's annual income stream would have grown to nearly Rs 21,500. In all, the investor would have earned Rs 96,000 as dividend income in last seven years, whose present value works to be Rs 115,000. At this rate of growth in dividends, the investor's annual income stream would balloon to Rs 50,000 by the 11th year and Rs 3.5 lakh by the 20th year. And remember this income is totally tax free. What more this cash flow doesn't require much involvement in terms of time or effort as dividend is electronically credited to the investor's bank account. Now compare it with the hassles involved in managing other assets such as real estate—an all time favourite investment avenue in urban India. 
    Though the dividend distribution policy varies across corporates, in case of companies such as Tata Steel, Tata Tea, Indian Hotels, ACC, Colgate Palmolive and GSK Pharma dividend account for as much as a quarter of the total shareholder return in last seven years. Given this, equity investors can ignore dividend as their own peril. Investing for dividends also protects investors from the wild fluctuations associated with equity markets. The growth in dividends is significantly less volatile than the movements in stock prices. Take the case of our portfolio. In FY09, the market value of the portfolio declined by nearly 40% but the dividend income fell by less than 1%. In tough times companies do scale back dividends payments but they have ample headroom to cushion the blow to their investors. 
    So critics are wrong when they mock at this strategy. India Inc has been steady with dividend distribution and most often this pot grows faster than the growth in either the profits or revenue. What looks like a small amount today will grow to a large source of income in few years time. You just have to be patient and little optimistic. 
    krishna.kant@timesgroup.com