Dividends are supposed to be a sign of confidence that the management has in the business. It is a sign that the business is throwing off excess cash. To quote Warren Buffet; "Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally" . Thus, if a business generates cash greater than its internal needs, we believe the management should return it to shareholders. The key issue is how this is done.
Many firms have a stated dividend policy. The annual report may state the percentage of profits the company will pay out. If the board of directors increases the dividend, it should imply that profits too have increased. However, we came across an article in the Economic Times that found the opposite to be true! 20% of companies that were analysed increased dividends despite a fall in the bottomline. If you own shares in such a company, should you be worried?
We believe the answer can be found only by digging a little deeper. The following questions should come to your mind. Was the profit decline only due to a one-off event? Is the business generating strong operating cash flow as before? Is the management struggling to find growth opportunities? Has debt been taken to fund the dividend payout? Unsatisfactory answers to these questions should ring alarm bells.
Keep in mind that the best dividend paying firms usually have a few things in common. Solid underlying businesses, shareholder friendly managements and strong operating cash flows are the most important ones. If this is not the case with the stocks that you own, you should not take the management's positive views at face value. It could be a case of promoters enriching themselves via higher payouts.
However, a temporary fall the net profit may not necessarily be a cause of worry. For example two of the companies listed by the financial daily, Bajaj Auto and Mahindra & Mahindra, had a challenging year in FY15. However, these businesses have a strong historical track record which investors will have to factor in. So while dividends are important, we believe it should only act as a starting point for your analysis. Dividends are not an end in themselves. What really matters is the state of the business that generated it. As is the case with most things in life, dividend investing is not as simple as it appears to be!
By Richa Aggrawal
Many firms have a stated dividend policy. The annual report may state the percentage of profits the company will pay out. If the board of directors increases the dividend, it should imply that profits too have increased. However, we came across an article in the Economic Times that found the opposite to be true! 20% of companies that were analysed increased dividends despite a fall in the bottomline. If you own shares in such a company, should you be worried?
We believe the answer can be found only by digging a little deeper. The following questions should come to your mind. Was the profit decline only due to a one-off event? Is the business generating strong operating cash flow as before? Is the management struggling to find growth opportunities? Has debt been taken to fund the dividend payout? Unsatisfactory answers to these questions should ring alarm bells.
Keep in mind that the best dividend paying firms usually have a few things in common. Solid underlying businesses, shareholder friendly managements and strong operating cash flows are the most important ones. If this is not the case with the stocks that you own, you should not take the management's positive views at face value. It could be a case of promoters enriching themselves via higher payouts.
However, a temporary fall the net profit may not necessarily be a cause of worry. For example two of the companies listed by the financial daily, Bajaj Auto and Mahindra & Mahindra, had a challenging year in FY15. However, these businesses have a strong historical track record which investors will have to factor in. So while dividends are important, we believe it should only act as a starting point for your analysis. Dividends are not an end in themselves. What really matters is the state of the business that generated it. As is the case with most things in life, dividend investing is not as simple as it appears to be!
By Richa Aggrawal
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