Software dividend yields: Are they relevant?

Source: EM
The ‘Big 3’ Indian software companies – Infosys, TCS and Wipro – announced their results for 1QFY07. The overwhelming feeling that one gets after hearing what the managements of these companies have to say is that these companies will continue to clock a strong 25% to 30% CAGR in topline and bottomline over the next three years.
The demand environment continues to remain strong for offshoring and the untapped potential is significant. However, this is not the focus of this article. In this write-up, we discuss the kind of dividend yields that software stocks (including hardware) in our universe give and what can be read into them.
What’s the yield?In his book, ‘The Intelligent Investor’, Benjamin Graham, the guru of current investing legend, Warren Buffet, says that the attractiveness of stocks can be judged from the kind of dividend yield that they return. He compares the dividend yield on stocks to the ‘risk-free rate’ i.e., the yield on the 10-year government bond. Theoretically, if the yield on the 10-year paper is higher than the yield on stocks, then stocks are expensive relative to bonds, and a portfolio must then adjust its asset allocation to maintain a bias towards bonds. Given the fact that stocks are inherently riskier than bonds, this theory seems to have a fairly solid foundation.
However, this does not take into account the ‘growth’ aspect of stocks. Given that in India, the bigger companies are expected to report earnings growth of around 14% to 15% in FY07, this should result in similar returns on the index. The dividend yield on the BSE Sensex is just 1.5%. This does not necessarily mean that investing in the index is unattractive, since it does not account for the ‘capital appreciation’ part of the equation.
It is clear that the 2 companies from the HCL stable – HCL Technologies and HCL Infosystems – score head and shoulders above their peers on the dividend yield front. Both these companies have a policy of announcing regular quarterly dividends. HCL Technologies has announced quarterly dividends for the last 13 quarters in a row and the last 12 months’ dividend per share comes to Rs 16. HCL Infosystems, on the other hand, has announced quarterly dividends totaling Rs 8 per share over the past 12 months.
On the other hand, the dividend yields for most of the other software companies are nowhere near those of the HCL Group companies. MphasiS BFL comes closest, with a dividend yield of 2.4%. Infosys’ dividend yield of 1.4% is partly due to the ‘Special Dividend’ that the company had announced in FY06 on the occasion of the company having completed a ‘Silver Jubilee’ (25 years) of existence.
While the quarterly dividend policy of the HCL Group companies is certainly an investor-friendly measure, these companies do not measure up to their peers when it comes to the ‘growth’ aspect. HCL Technologies has consistently under-performed its peers in the sector. HCL Infosystems, on the other hand, operates in a highly competitive industry where the market share can change every quarter (operating margins of just 3.3%). Even its major business, the distribution of Nokia GSM mobile phones, has suffered a setback with the latest deal signed with Nokia.
At the same time, companies like Infosys, TCS and Wipro have been consistent and superior as far as their earnings quality is concerned. The growth of these companies has been accompanied by significantly less volatility than that of HCL Technologies. Therefore, in terms of growth prospects adjusted for risk, these companies could actually be better bets.
ConclusionThus, in a growth-oriented industry like software, the ‘dividend yield’ is not so relevant. Even if a particular company does appear attractive in terms of the dividend yield, this cannot be the only criterion to judge as to whether the stock is an attractive investment. One must consider factors like management quality, consistency and quality of growth, track record, future growth prospects and execution capabilities before taking an investment decision. This rule applies to every stock/sector.
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