Sunday, April 30, 2006

Dividend yields that beat FDs

Very few of the investors realize the immense potential of regular
income from equity investments. If you choose your investments
carefully, it is not only possible to get some regular income from
investments but the dividends can beat the returns from fixed deposits.

Let me explain the essentials of the approach to achieve this result.
When an investor invests for the long term he would mostly focus on
the long term capital appreciation rather than the current income.
Also any good company will generally find a way to reinvest the
profits in the core business and distribute only 20-30% of profits to
the shareholders which may not amount to a good yield relative to FDs.
For this reason it is difficult to find good companies at fair prices
to get a good dividend yield while provide chance of capital

You see a real example open the LWB Special portfolio in a new window
by clicking link 'LWB Special Portfolio' in the home page. In the
second last column you would notice that dividend yields of the
companies at current market price are in the region of 2 to 3%, with
the average at 2.42%. So an investor in these stocks would be getting
2 to 3% dividend yield.

But those investors who bought the stocks when the model portfolio was
started are getting a dividend yield ranging from 2 to 16%. If you
take the average you would be surprised to know that these investors
(myself included) are earning 6.3% dividend yield on their original
investment. So these investors not only enjoy 160% gains in 2.7 years,
they are getting 6.3% returns on investment which is better than a
fixed deposit with a bank.

This example brings us to the main features of a portfolio with a view
to high income.
1. The portfolio should not be made just by viewing current dividend
yields. Many companies pay good dividends when sun shines but send no
cheque when dark clouds loom over the horizon. A consistent dividend
record plus the future growth would ensure that the dividends cheques
keep coming to your doors.

2. If the companies keeps giving good dividends but the investment
itself is under threat due to unrecoverable fall in prices the
dividends are of no use. So the investment decision should still be
based on capital preservation and growth.

3. Most companies retain their dividend percentages after bonus
issues. So the investors holding steadily growing can see higher
dividend yields in the future.

4. The dividend payout by a company not only depends on the profits
but also on the planned capital expenditure. A company which plans to
spend on new plants etc will not be able to pay good dividends. That
does not mean that this low dividend yield would continue forever.

5. Although a fixed income deposit carries the return of the principal
amount and a fixed yield in terms of money. This fixation is a double
edged sword. Although the fixed income deposits provide lower risk in
normal circumstances, these are subject to the threat of inflation. If
the value of money goes down the real value of your principal and the
real value of the interest go down. In a era of 6% inflation if you
hold 5.5% FD, the main danger is not that you are loosing 0.5% in real
terms but the fact that principal amount would be worth much less when
you get it back at the end of the term.

Equity investments are relatively safer under inflationary scenarios
because the value of assets and the prospective yields go up along
with the prices.

6. The interest on fixed deposits is subject to taxes (at source if
>2500) whereas the dividends are free in the hands of the investors.
This means a dividend yield o 4.-4.5% is preferable over FD of 5.5-6%

With these points in mind an enterprising investor can build a
portfolio which can give a decent income after 2-3 years have passed
while enjoying the benefits of capital gains.

Posted: Aug 27, 2004

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