What type of stocks should I buy given the present uncertainty on the stock market’s future direction?
It is always very difficult to determine whether we’ve seen the worst or if it is still in a situation pending a major market correction. Although there are a lot of uncertainties over the market’s future, we can still invest if we are able to find stocks paying good dividend yields.
According to Benjamin Graham and David Dodd in their book, Security Analysis, the price paid for a stock would be determined chiefly by the amount of the dividend paid. A good company should pay dividends. This is one of the best ways to reward shareholders. Besides, we always believe a bird in hand is worth two in the bush.
Stocks paying good dividends will provide us with a “floor” if the market is undergoing a correction.
For example, Company A has a stable business and is paying a relatively fixed dividend of 32 sen a year. Its dividend yield (DY) will be equivalent to 5.3% based on the market price of RM6. This is quite attractive if we compare it with the current 12-month fixed deposit (FD) rate of 3.7%.
Assuming, as a result of a big market correction, its stock price tumbles to RM5, then its DY will surge to 6.4%. This will make Company A even more attractive compared with FD rates.
Certain investors may be worried whether Company A’s business will be affected by the slowdown in the overall economy. If its business is consumer-based with relatively stable demand, its sales and profits will be less affected by the economic slowdown.
Besides, as most companies are trying to maintain a fixed dividend payment, investors can still enjoy good dividend returns. Sometimes, the over-reaction to a market crash may be much greater than the drop in profits. This will give investors another great opportunity to buy the stock at a lower entry price. If investors are prepared to hold on to the stock over the next five to 10 years, a lower entry price will give us greater capital gain.
Certainty of DY versus potential earnings growthUnfortunately, there are some companies that are not so willing to share their cash reserves with minority shareholders. The most common excuse used is that they want to retain the cash for working capital or for future expansion.
By announcing several positive corporate proposals, the company may mislead the investing public on the potential of its future growth.
They may not be aware that the actual return to the investors could be very much different from what they had anticipated from the company’s growth.
That explains why a stock with potential earnings growth of 15% plus a 1% DY could be sold at a much higher price than a stock with 11% growth and a 5% DY - a scenario that kept John Neff, a well-known investment guru and fund manager for Windsor Fund, puzzled.
A company usually tries its best to maintain its dividend payout policy. Thus, the certainty of DY should command more value compared with the uncertainty of future earnings growth, although the latter may translate to higher future dividend payout.
However, there are companies that have high turnover but incur losses every year. We may wonder why these companies’ owners are willing to be involved in a loss-making business. Most of the time, they make small losses but on the back of a couple of hundred million in turnover.
This may be attributed to the genuinely tough business environment, or sometimes, tax avoidance purposes. These companies will normally not declare any dividends. Thus, the investors will not receive any income returns. Also, as a result of small losses every year, the depleting reserves will further weaken the stock’s market price. Apart from receiving zero income returns, investors will also incur capital losses over the longer period.
