Now that the growth story of the Indian economy is well established, it is no surprise that investors in equities are now expecting strong compounding of returns in the mid to long term. While it cannot be denied that growth is going to be the mainstay of wealth creation as a source of wealth creation for investors in the near future, there is another aspect here: are dividend stocks or mutual funds better?
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According to Shiv Chanani, Senior Manager, BNP Paribas Mutual Fund, the Nifty 500 index has shown a compounding growth of 12.5% from January 2000 to July 2024, while the Nifty 500 TRI index (total return index which includes dividend payments) has grown at a compounding rate of 14.2% during this period. It is clear here that dividends have added an additional 1.7% return on top of the return. Now, here 1.7% additional return may not seem very significant to many investors, but let’s see what has happened in the last 24 years. If someone had invested Rs 1 lakh in Nifty 500 TRI in January 2000, then its value has now become Rs 26 lakh, whereas the value of an investment of Rs 1 lakh in the Nifty 500 index during this period has become Rs 18 lakh (ie, without dividend). Dividends alone have contributed more than 30 per cent to the total return in the last 24 years. (Source: Data as on July 31, 2024. Source: MFIs and Internal Research.) So, while growth is the cornerstone of equity investing in India, ignoring the contribution of dividends to overall returns could be a grave mistake.
Shiv Chanani says that when it comes to stock selection, dividends are an indicator of companies that can grow consistently over time. As the old saying goes, “Turnover is vanity, profit is wisdom and cash is reality” – dividend payments are the biggest indicator of a company’s ability to be cash rich and consistently generate profits. As we know, most companies require capital to grow and expand and there are only three sources of capital available – fresh equity, debt and internal accruals. Of course, the first two have limitations and as a result, if a company is to grow consistently over time, it will need to generate consistent free cash flow. Consistent dividend payments ensure a company’s success in achieving the ability to consistently generate predictable free cash flow. In fact, our internal research shows a direct correlation between companies paying regular dividends and generating free cash flow.
Another key characteristic of dividend paying companies is that their stocks are generally less volatile than the overall market when it comes to share price fluctuations. More importantly, these companies’ stocks are less likely to see a sharp correction as the dividend yield starts to become attractive and a natural bottom is formed for the share price. In fact, our research shows that the beta of Nifty Dividend Opportunity 50 TRI compared to the Nifty 50 index is 0.82 over the last 5 years. (Source: Data till 31 July 2024. Source: MFI and Internal Research.)
There is a misconception that low volatility and better dividend yields will be associated with companies with low returns and low growth. However, this is not true. There is no need to make a trade-off between growth and consistent dividend payments. Investors can consider dividend-paying companies to be of the same quality as a skilled batsman. A good batsman not only has the ability to hit the ball out of the boundary line but also has the ability to take singles and score runs to consolidate the innings. Similarly, dividend-paying companies help in enhancing returns not only through the appreciation in the stock price but also through consistent dividend payments over a period of time.
Speaking of misconceptions, some investors may also think that dividends are only paid by large companies, or they are only paid by companies with low capital intensity. Once again, these are myths and misconceptions. Dividends are paid by companies with varying market caps, including mid-cap and small-cap companies. Moreover, companies from different sectors, including the capital incentive sector, are known to pay dividends.
In short, investors should understand that dividends play a key role in returns, especially when they are compounded over the long term. Dividends are the best way to determine if a company is generating free cash flow. Finally, dividend payments need not be at the expense of growth. In fact, most of the time they are known to go hand in hand, i.e. companies that pay dividends often see growth.
Disclaimers: The sector(s)/stock(s) mentioned do not constitute any recommendation of the same and Business Today Bazaar will not be responsible for any loss or profit.