When a company earns a profit, it often rewards its shareholders by passing on a percentage of its profits. This is commonly called a dividend payment or payout. There are investors in the stock market who target stocks of companies that have a history of paying higher dividend.This become even more rewarding if the dividend payment is relatively higher compared to the price of the stock. For example, there are two companies, each of which paid dividends of Rs.10 per share. The stock price of the first company is Rs.100 while it is Rs.200 for the second one. The dividend yield in the first  company is 10% while in the second it is half of that, which is 5%. Here, the dividend yield in the first company’s stock is higher than in the second one’s. In other words, dividend yield is the payment you receive by investing in the stock of a company.

In India, dividend in your hands, that is in the hands of the investor, is completely tax-free. This is because while paying a dividend to its shareholders, the company directly pays a tax on the same to the government. This tax-free treatment also makes targeting higher dividend yield all the more lucrative for investors.

Going by the example given above. You can see that lower the price (Rs.100), higher the dividend yield (10%). Seen another way, if you buy two stocks of the first company for a total of Rs.200, instead of one stock of the second company for the same amount of money, you get Rs.20, that is double the amount in the second company. So naturally, as an investor you should target stocks with higher dividend yield.

Such practice of targeting higher dividend yield has its virtues. There are two aspects to this approach of investing in stocks with high dividend yield, said Gajendra Kothari, MD & CEO, Etica Wealth Management. One is this is a very conservative approach where chances of loss is very low. The other is there is an inherent process of asset allocation under this approach, a built-in, self-correcting mechanism, Kothari said. When the market goes up and stock prices are higher, the dividend yield automatically fall. On the other hand, when markets are falling (like it is now) and stock prices are also low, dividend yields rise, he explained. The corrections are automatic.

Going to the market directly and buying high dividend yield stocks in one approach. However, if you are not very efficient or trained adequately to go to the market directly, the other way to reap then same benefit is to invest in schemes of mutual funds that target dividend yields. In these schemes, for a nominal fee, the fund house would do the job for you: that is build a portfolio of stocks of companies with solid dividend payment record and pay you dividend as they get the same from the companies they have in their portfolio. Currently, there are about seven to eight schemes based on the theme of dividend yield, some targeting large cap stocks, some mid cap and some small cap ones. According to your risk profile, choose the one that suits you the best.

But how does a dividend yield scheme work? There are some basic rules that these schemes follow. First, since dividend yield on a stock in inversely proportional to the price, the fund manager first looks at stocks with higher dividend yields. The next is to look at high cash flow, that is companies which generates higher level of cash. This is important because unless the company has substantial cash at its disposal, it won’t be able to pay good dividends. Whereas a company that has a stable business and growing at an above average rate, would probably pay a good dividend. That brings us to the third attribute, that is to look for stocks of companies with a history of paying good dividend.

Historical studies also show that dividend yield funds usually do well in all type of market conditions, expects when there is a sense of euphoria on the bourses. For example, during the three years beginning 2007 – the period that witnesses an euphoric phase, followed by a crash and then a recovery – the high dividend yield stocks among large cap companies (with a market capitalization of more than Rs.16,000 crore) with in NSE’s  CNX 500 index gave a 26% return over the index. Compared to this, the relative performance of the nifty index was marginally negative and that of the sensex was marginally positive.

Similarly, a relatively much higher return was seen during the three years starting December 2006. During this time, the sensex out performance relative to the index was 26.7%, Nifty’s 31.1% while the high dividend yielding large cap stocks triumphed with a comparative higher return from a universe of high dividend yield stocks were nothing spectacular between early 2005 and early 2008, the period known for its sharp up move, followed by a euphoric trend on Dalal Street. “In a euphoric market, there are chances that these (dividend yield) schemes may lag in their performance, said a fund industry veteran.

Another positive attribute that has come out from various studies is that the net asset values (NAVs) of dividend yield funds show lower fluctions compared to NAVs of most other types of equity funds.

Given the very nature of a dividend yield fund, these funds turn more popular during periods of market uncertainly, volatility and also downturn. During market slides, such sticks offer good returns in the form of a stable dividend income. One the other hand, when the markets are good, these funds may not offer a good income in the form of dividend, but they usually lead to capital appreciation, that is rise in the value of your investments. In India, historically FMCG, pharma, banking and energy companies have paid good dividend. But the trend is changing.

Another set of companies that pay good dividend are the PSUs. Most PSUs are well established companies but do not have high growth ambition. Also, the government, like from other sources, also needs money from these companies. So usually PSUs are also under pressure to pay higher dividend to the government. Historically, PSUs in India get lower valuation compared to their private sector peers. So their stock prices are usually lower compared to their peers from the private sector. But since PSUs pay higher dividend, dividend yield on these stocks are also higher. Investing in PSU stocks for regular dividend makes sense since whenever PSUs have to pay to their promoter, that is the government, as a minority share-holder you will also get a dividend by the same amount. It is no wonder that dividend yield funds also target PSU stocks in a big way.

In a number of developed markets, there is a culture of paying higher dividend so that the yields are in high single digits or in low double digits. In India however, that is not the case. So here dividend yield schemes often complete with funds that aim to grow your money by investing in good stocks.

Financial planners and advisors often suggest these funds to investors who are risk averse and yet look for regular returns. They also say that there should be some exposure if these type of schemes in every investor’s portfolio because while in a good market pure equity schemes would grow your investments faster, in items of downturn and uncertainly dividend yields funds would be able to give some much needed stability to you protofolio.