The origins of dividends, why they are paid to shareholders, why dividend yields are low in India and a high dividend portfolio revealed.
“What exactly is a dividend, Vikram?”, I asked as we were sitting across the breakfast table in Vikram’s apartment in Mumbai. To escape the New York City cold, I had decided to pay a long visit to my friend, Vikram, from my alma mater days.
“Of course, you know what dividends are, Whittle. They are the share of profits that a company pays to its shareholders. But since you have asked, let me explain. I know this is Finance 101 basics but it always helps to review.”
“A company is formed by the coming together of several individual shareholders or investors. The shareholders invest capital in the business as equity and are given “shares” in the company. Another set of investors also invest capital in the company and are called bond holders. These investors are promised a specific interest rate on their capital which will be paid to them regularly.”
“With the capital put together, the company operates as a single entity run by its board of directors and managers. On a periodic basis the company reviews its operations and prepares its income statement which specifies the revenue and expenses of the company during that period. The cash flows from the customers provide the money to pay for its expenses. The bond holders are paid interest from these cash flows.”
“If the company has more revenues than expenses, then the company is profitable. From these profits, it is a general practice to pay out a portion as dividends to shareholders. These practices have evolved over several centuries starting in 1602 in Holland with the formation of the Dutch East India Company.”
“Yes Vikram. The Dutch East India Company was probably the first company which had permanent existence and paid dividends for more than 100 years. But what puzzles me is why did they pay dividends at all? The company could have reinvested the profits and kept growing.”
“Whittle, the Dividend Puzzle still puzzles economists today. However, there are some possible explanations. Think about this. Bond holders get paid interest whether the company has profits or not; but what do shareholders get? They take the risk of their capital being destroyed if things do not work out for the company. That is why, when there are profits, it is a general practice to pay out a portion to the shareholders. This not only pays them returns for their investments but also signals to the shareholders that all is well with the company.”
“Vikram, this makes sense. However, what still puzzles me is that the dividend yields in India are quite low. They are around 1% to 2% for most companies. While they could make around 5% in bonds. Compare with the US companies, where there is a class of companies which sport dividend yields of 2% to 4%+ which is similar to the bond holders in the US.”
“Whittle, most Indian shareholder have not yet appreciated the value of investing in stocks for their dividends. Indian shareholders, typically, invest in bonds for their income and stocks for the potential capital gains. They have completely missed out on the class of stocks which provide a high dividend yield while also providing strong chances of capital gains.”
“I am wondering Vikram, while I am in India, should I invest in some bonds to earn income. This way I could earn something higher than my bonds in the US and not have to dip into my capital for my expenses here.”
“I have a better idea for you Whittle. I know you can take a lot of risk and have a large stock portfolio in the US. I will let you in on a secret about dividends in India. There is a portfolio of Indian dividend stocks which could provide you yields which are higher than the bond yields. Further, there is a potential upside from the capital gains. But remember, this is equities and dividends. Neither the principal, nor the dividends are guaranteed. The stocks could drop in prices and they might not pay dividends or pay out much less in the future than what the dividend yields indicate.”
“That sounds interesting, Vikram. Can you talk more about this portfolio? What is the dividend yield? What do these companies do? Why do you think the dividends would sustain? What about potential capital gains or growth? What are the risks?”
“Mr. John Whittle, given that you understand the risks of equity investing, I present to thee—the Omni Super Dividend, the portfolio which yields around 8%. While you can learn more about this on Newsbarons, I will discuss more about this.”
“Thank you, Prof. Vikramaditya! I look forward to learn more about this portfolio from you. The game is on!”
Disclaimer: Equity investments are subject to market risks. Global investments entail currency and country risks. The above is not a recommendation to buy, sell or hold any of the stocks or sectors mentioned. We and our clients might have exposure to the above-mentioned stocks or sectors. Please consult your investment advisor and assess the suitability of investment products for your circumstances before investing. Please read the detailed disclaimer on omnisciencecapital.com/disclaimer.
[This is an authored article by Dr. Vikas V Gupta, CEO & Chief Investment Strategist at OmniScience Capital. All views, opinions and expressions are personal and limited to the author.]