Should you invest in Dividend Yield funds

In the last few years high dividend yield stocks have caught the investors fancy. Mutual funds investing in high dividend yield stocks are also catching the investor’s attention. The appeal of high dividend yield stocks in understandable especially in an environment of uncertainty. Dividends ensure that investors receive regular income when investors do not have sufficient visibility into the scope of capital appreciation in the short to medium term. In this blog post we will discuss if high dividend yield stocks or dividend yield funds are the best investment options for you.

How and why companies pay dividends?

The profit made by a company from its operations is known as the operating profit or in accounting terms, EBITDA (Earnings before Interest, Depreciation and Amortization). This money does not belong to the shareholders of the company because two important stakeholders of the company, the lender and the Government, have to be paid first. From the operating profit or EBITDA, the company first pays interest on loans taken from creditors (lenders). Depreciation and amortization do not involve any cash-flows; they are accounting items that help the company reduce their tax obligation. The profit after paying interest and accounting for depreciation / amortization is known as profit before tax. The profit after paying tax to the Government (PAT) belongs to the shareholders.

A portion of the PAT is distributed to shareholders in the form of dividends. Dividends are paid on a per share basis. The remaining portion of PAT is retained by the company and goes to the Retained Earnings account of the balance sheet. The retained earnings are re-invested by the company for future business growth. Investors should understand that, the entire PAT belongs to the shareholders, not just the dividends. Dividends give shareholders income while the retained earnings will give them capital appreciation in the future. You should understand that the dividend amount is entirely at the discretion of the management of the company.

Are high dividends desirable?

It depends on the investment objectives of the investors. If the investors want regular income from their investments, then high dividends are certainly desirable. However, from a total return perspective, paying a large part of PAT as dividends can have several interpretations. Some investors may interpret this as lack of business expansion opportunities for the company. If business growth and consequently earnings growth is constrained in the future, this has implications on the share price increase and capital appreciation for shareholders.

This is not the only interpretation. Some investors interpret high dividend payout rate as sign of pragmatic management which takes care of shareholder interests. High dividend payout rate is seen by these investors as sign of the financial health of the company. These investors are not concerned with lower plough back (retained earnings) and argue that, if the management of a company invests in business expansion, it does not automatically imply higher future earnings because many a times these investments go wrong. Renowned finance expert Professor Aswath Damodaran of New York University has shown that, mergers and acquisitions (M&A) have usually destroyed shareholder value.

Some financial planners argue that, dividend policies are irrelevant from an investor’s perspective, because investors have the ability to create regular income through asset allocation. Let us understand this with the help on an example. Suppose you want 5% dividend yield from your equity investment. You can get the same pre tax income by investing 63% in an 8% coupon bond (or an accrual debt mutual fund giving around 8% returns) and investing the balance 37% in a growth stock or equity fund which does not pay any dividend.

However, we cannot ignore the taxation aspect. Interest earned from most bonds or NCDs are taxed as per the income tax rate of the investor. Short term capital gains from debt funds are also taxed as per the income tax rate of the investor and in dividend options, fund houses have to pay dividend distribution at the rate of 28.8% before paying dividends). Dividends paid by stocks or equity mutual funds are tax free.

The tax argument can get a little complicated if we compare dividends versus capital gains from a shareholder value perspective. Some investors argue that while dividends are tax free in the hands of the investors companies have to pay dividend distribution tax (@ 20.3% including surcharge and cess). Money paid in taxes does not create shareholder value. If the company does not pay dividends, it can re-invest the entire PAT in future business growth, which can result in tax free long term capital gains for the investor.

There is a school of thought in favour of high dividend yield, arguing that shareholders should decide what they want to do with their money. With higher dividends shareholders can decide whether they use it to meet expenses or invest in stocks which have higher growth potential. The counter-argument is that, if shareholders know of better investment opportunities, then they always have the option of selling the shares and investing elsewhere.

Warren Buffett and dividends

The legendary investor, Warren Buffett, has often extolled the virtues of high dividend yield stocks. Some of Berkshire Hathaway’s largest and longest held investments like Coca Cola, American Express etc are all high dividend yield stocks. Out of around 50 publicly traded stocks owned by Berkshire Hathaway, 35 stocks pay dividends and dividend yield of some stocks are 4% (almost twice the average 2.3% dividend yield of Dow Jones). Let me now ask readers a question now. How much dividend did Berkshire Hathaway paid its shareholders? The answer is zero. Berkshire Hathaway has never paid dividend only once (in 1967) to its shareholders. Is there is contradiction in this example?

Let me explain first, why Buffett likes dividend paying stocks. In his words, he likes these companies because they pay him to own them; in other words, the management takes care of the shareholder interests. Secondly, he likes companies which have high ROE. There is empirical evidence suggesting that, high dividend yield stocks have superior ROEs. Consistent dividend growth track record shows the earning power of a company and sustainable competitive advantage.

Let me now explain, why Buffett does not pay dividends to Berkshire Hathaway shareholders. He believes in optimal capital allocation for his shareholders. He believes that, re-investing in his own business will create more value for shareholders. The contradiction between Berkshire Hathaway’s dividend policy and its stock selection shows that, Buffett wants management of companies he owns to focus on generating free cash-flows, but he has faith in his own abilities as far as re-investing the cash-flows generated by his assets. Buffett’s approach to dividends has important lessons for mutual fund investors. Some investors have told me that, they prefer dividend options in mutual funds because they think “it is wise to take out profits from time to time”. In my view it is very unwise, unless you know how to use the money. Buffett likes dividends because he can put the money to its most efficient use. Fund managers book profits from time to time and they are able to put the money to its most efficient use, to generate higher returns for the investors. You should not invest in dividend options for the sake of booking profits; if you do not need income from your investments, then you should invest in growth option and let the fund manager decide how to re-invest the profits.

Should you invest in dividend yield stocks?

I can understand if readers are a little confused with all the arguments and counter-arguments for and against dividend yield. We shared different points of view because there are investors with different risk profiles, investment temperaments and financial objectives. If you need income from your investment then you should invest in dividend yield stock. If your investment objective is capital appreciation then you should make a decision based on your risk preferences. High dividend yield stocks will provide regular income and reduce your portfolio volatility especially in bear markets. These stocks are suitable for investors who have moderate risk appetites. If you have high risk appetite you can invest in growth stocks. In bull markets, growth stocks outperform dividend yield stocks. Over a very long investment horizon, both growth stocks and dividend yield stocks, have the potential to give excellent returns.

Dividend Yield Funds

Mutual fund investors should note that, even though dividend yield funds are likely to receive dividends from their stock holdings, there is no onus on the mutual fund schemes to declare dividends. You should look at the dividend pay-out history of the schemes and see if they have paid dividends consistently. You can look up the dividend pay-out history of any mutual fund scheme in our MF Research section by using our tool, Mutual Fund Historical Dividends.

If you want to reduce the volatility of your investment portfolio, you can invest in dividend yield funds. High dividend yield funds are by nature value funds (high dividend yield implies that, the stock price relative to the dividend is low). Value funds can underperform for extended periods and hence investors need to be patient. However, over a full economic cycle value funds can give excellent results. Therefore, investors need to have a long investment horizon for dividend yield funds.

Conclusion

Mutual funds offer a wide variety of investment choices for a spectrum of investor needs and preferences. Every investor has specific investment objectives. In Advisorkhoj, we try to describe different characteristics of the investment choices available to the investors and their suitability for specific needs, so that investors can make informed decisions. Investors should evaluate if dividend yield funds are suitable for their investment portfolios in consultation with their financial advisors.