Dividend-paying firms offering decent yields will remain attractive

Image via Shutterstock
The post-Budget rally has injected some optimism into a market which was down and out. It started as a relief rally in the bond market and it seems to have translated into a generic pullback. The equity market is up with fair breadth and good volumes. The Sensex and Nifty have gained seven per cent in five sessions.

It remains to be seen if this is a full-scale turnaround in sentiment. The sustainability of the rally will largely depend on global attitude. If foreign institutional investors (FIIs) are selling in quantity, buying from domestic institutions plus retail is not going to be enough to prop up the market.

Read more from our special coverage on "MARKET INSIGHT"

There has been one very unusual factor to the rally. It is early into the settlement, and the stock market has headed up. When the market is trending up, the futures market usually trades at a premium to the underlying. Yet, through the past few sessions, index futures have traded at serious discounts to the respective underlyings.

Normally, a big futures discount to the underlying occurs only close to the settlement, or during a bear market, when traders expect cash prices to fall and short derivatives.

Why is the cash market running at a premium to futures and options (F&O)? The explanation starts with the basics. In this instance, people are buying underlying stocks but not buying the index futures with commensurate volumes. So, the underlying indices have gone up but the futures have not gone up by the same amount. This leads of course, to the next question: Why are traders and investors doing this?

Here we enter the realm of speculation. The change in the dividend taxation rule has led to strong rumours that many corporates will produce large interim dividend payouts within this financial year as a sort of farewell gift.

Serious investors who earn more than Rs 10 lakh per annum from dividend will be hit by the new tax, as they will have to pay 10 per cent tax on the dividends received. This impacts holding companies and mutual funds. For example, Tata Sons would have paid more than Rs 4,000 crore if this tax had been in force in the 2015-16. It also impacts major promoters since the who's who of India Inc lives off tax-free dividends. Let's not get into the logic or justification for taxing dividends in this fashion. However, strange or illogically structured this tax might seem, it creates an incentive to rework dividend payouts in the time that remains before the new tax comes into force.

Again, there is not much point to debating the pros and cons of the rumours that big dividends will be paid in 2015-16. This may be true, and may not be true. It could be partly true in that some companies will do it and others will not.

It is not a good year for massive dividend payouts because profits have been low. On the other hand, there is little private sector investment at the moment. So, arguably, corporates may as well dip into reserves and hand over some cash to shareholders. What is more, we know that quite a few promoters had increased their stakes in their own companies prior to the Budget. So, they could be looking to hike dividends anyway.

Working on this logic, there's been delivery-based buying of stocks which have a solid history of paying dividends. Perhaps there will be disappointments and exits if dividends are not hiked after all. But that won't happen until we enter the next financial year.

In the long run, introducing double taxation (triple taxation for the shareholder of a mutual or a holding company who receives a dividend) may lead to changes in the way that people organise personal finances. It could also lead to differences in the way corporates organise dividend payouts.

Nevertheless, despite the additional burden, a dividend chasing strategy may remain a good way to build a portfolio in a bearish market. An investor who receives pre-tax income of Rs 10 lakh from debt will pay out roughly one-third of that as income tax. In contrast, an investor who receives Rs 10 lakh as dividend will pay only 10 per cent tax. Net-net, the dividend investor would still gain.

Dividend paying companies, which offer decent yields will remain attractive. Given the bearishness of the previous 11 months, there were, and still are, many such companies. In addition, everybody expects interest rates to continue falling. So, despite the higher tax outgo, the long-term investor could still rate dividend as a major factor in buy decisions.

Business Standard is now on Telegram.
For insightful reports and views on business, markets, politics and other issues, subscribe to our official Telegram channel