With interest rates on a downhill ride, it may pay to invest in high dividend paying stocks.
The days of earning double-digit returns from fixed deposits are long gone. Fixed deposit rates across tenures have tumbled in the past few quarters. Private sector banks, for instance, have reduced their rate to 6.5 per cent for deposits of 180 to 364 days. As you increase the tenure of the deposit - from 365 to 390 days - the rate goes up by a marginal 25 basis points, or bps, to 6.75 per cent. This is perhaps the highest rate one can currently earn on fixed deposits across tenures. While you may earn a tad more (0.50 bps) if you walked over to a public sector bank, it's not really high.
In fact, the key benchmark interest rates are currently at multi-year lows. Repo and reverse repo rates are 6.25 per cent and 5.75 per cent, respectively. "Low inflation in the past few years has helped the Reserve Bank of India (RBI) reduce interest rates consistently," says Dinesh Rohira, Founder & CEO, 5nance.com. Further, banks are flushed with huge deposits owing to demonetisation (close to Rs 15 lakh crore), with little credit growth. This has allowed them to lower their lending and deposit rates considerably, in order to push lending. According to experts this isn't the end, and rates could fall up to 0.50 per cent this year.
Low interest rates are here to stay
Although this spells great news for the economy, as businesses will be able to borrow money at lower rates, borrowing rates for individuals, too, will fall, enabling them to spend more. However, this does not augur so well for your investments. Returns from fixed deposits, for instance, are at multi-year lows of 7 per cent, or even less. This means if you invest Rs 1 lakh in a five-year fixed deposit, you will earn Rs 7,000 as interest per year. Now, if you are in the highest tax bracket, you will pay 30 per cent of the interest earned as income tax, that is, Rs 2,100, bringing down your net earnings to Rs 5,000, a return of 5 per cent. This hardly beats inflation.
Look for options that not only offer consistency in returns but are also low-risk. One good option meeting these criterion are high dividend-paying stocks and funds. "Dividend yielding stocks often offer investors the safety of annualised payouts (and also the benefit of zero tax if certain thresholds such as dividend income of Rs 10 lakh are not crossed), irrespective of the volatility in price movements of the underlying stock," says Siddharth Purohit, Senior Equity Research Analyst, Angel Broking. Going ahead, lower interest rates will help consumption, which may also improve corporate credit offtake in the midium term. "Considering all this, the equity market is positioned reasonably well to deliver above average growth. Hence, investing in dividend yielding stocks makes sense from the risk-averse investor's perspective," adds Rohira. Companies that pay high dividends are known to be less risky when compared with others considering they offer consistent growth and have large cash on their books. Owing to this, these stocks tend to fall less than growth stocks during a downturn in the market. Moreover, many companies shy away from cutting dividends even in tough conditions, since this sends a negative signal to the market. "If there is uncertainty on the earnings trajectory and general macro or micro economic indicators are weak, these high dividend paying companies offer solace to investors," adds Purohit.
Factors to consider
A thorough due diligence before investing in these stocks is critical. "Investors must check the business in which these companies are, and whether these businesses have a viable and sustainable growth outlook," says Purohit. They also need to see if the earnings momentum that these companies show can be maintained.
Another essential point, he adds, is checking the promoter shareholding pattern, as companies with larger promoter holding tend to reward investors with regular dividend payouts as it is accretive both form earnings as well as taxation perspective, subject to limits set by regulators.
The pedigree of the management in running companies definitely matters, and so do the cash-flows these companies generate in the normal course of their business operations. "Market capitalisation, average dividend yield, average profit growth and valuation parameters are some of the good indicators for you to select the best dividend yielding stocks," says Rohira.
Investors typically tend to compare dividend yield on equity investments with their savings bank interest rate. "Therefore, any stock with consistent dividend yields in excess of savings bank interest rate, offering decent capital appreciation, while belonging to a credible promoter group is a sound investment option," says Pankaj Pandey, Head of Research, ICICIDirect. Hence, dividend yielding stocks appear most lucrative in a low-interest rate scenario where fixed income yield is lower.
Having said that, whether these stocks can be a substitute for your regular income must be gauged keeping in mind your risk-taking ability, investment horizon, as well as liquidity requirement. At the end of the day, it is an equity investment. Unlike your interest payments, which are fixed and regular, dividend payouts depend on the performance of the businesses, which may differ from quarter to quarter, not to mention the volatility in stock prices. "One thing is certain: good dividend paying companies shall also deliver better returns in terms of price performance over a longer period of time as their business models and earnings shall grow at a compounded pace," says Purohit.
It must be noted that high dividend yielding stocks with consistent track record usually do well in most market conditions, but underperform in extreme bull markets due to lower growth probability. Generally, mature companies that have passed their stage of explosive growth tend to offer high dividend yields. On the other hand, high-growth companies tend to plough back their surplus cash into the business, thus offering higher growth and, hence, more appreciation in a bull market.