Equity markets continued to strengthen and our portfolios continue to do well. The strength was led by stocks like HDFC and HDFC Bank, which have been trading, for long, at prices well below intrinsic value, for reasons that have no linkages to business fundamentals – a favorite sort of mispricing for us. The strong portfolio performance in the current financial year is well ahead of the growth in intrinsic value of the holdings as stocks have played catch up with intrinsic value. At this point, opportunities to invest in ‘significantly’ undervalued opportunities have reduced compared to the situation about a year ago.
Apart from intrinsic value growth of companies, and buying stocks at discount to intrinsic value, dividend is another component contributing to shareholder return – a component which is not much talked about. Sensex and Nifty have historically traded somewhere between 1.1% – 1.8% dividend yield on average (compared with a 6% post tax yield on a bank fixed deposit). This seems small when you consider that the aggregate price return for these indices has been close to 15% pa over the long term. Unlike bank interest, dividend from equities grows over time as profits of companies increase with passing time. Companies typically pay out a certain proportion of their profits and free cash flow as dividends.
We looked at a collection of superior companies that we track closely and tried to understand how much dividends contributed to their overall return over the last 20 years. The Sensex is up about 8 times in the last 20 years. For many high quality companies which consistently generate free cash flow and are also growing reasonably, just the dividends received provided a return which is higher than what the Sensex delivered over these 20 years.
For example, HDFC Bank traded at an average price of Rs 8.5 in FY1997 (adjusted for bonuses and splits) and paid a dividend of Rs 0.16 in that year (dividend yield of 1.9%). In FY2014, HDFC Bank paid a dividend of Rs. 6.85 per share (and continuing to grow) which translates to an 80% return on the original investment in FY1997. Hero Motocorp (erstwhile Hero Honda), a high free cash flow generator, traded at an average price of Rs 24.5 in FY1994 and gave a dividend of Rs 0.54 in that year (dividend yield of 2.2%). In FY2014 alone, Hero Motocorp gave a dividend of Rs 65 per share, about 2.5x the original investment. The cumulative dividends of Hero Motocorp over the last 20 years is Rs 546, which is 22x the original purchase price. If one had reinvested all dividends back into the same stock, you would have made 80x the original price on just dividend reinvestment, in addition to the 100x one would have made on price appreciation. Needless to say, we have picked Hero Motocorp to illustrate an example because it is one of the top performers over the last 20 years, but the rate of return provided by dividends alone has outperformed the market indices for a fair collection of high quality companies.
These numbers are fascinating because one often tends to forget the dividend return as a round off number and not pay much attention. But for companies that are growing consistently and generating free cash flows, dividends can add significantly to the overall returns, provided one is willing to invest over the long term.