High yields do not always mean best investments

While it is tempting to buy the highest dividend paying stocks, it is important to look at returns of the company, its fundamentals and the liquidity of the share.

"Investors should always focus on total return which includes dividend income plus potential capital gains," says Jawad Mian, portfolio manager at QInvest.

And high dividend yields don't necessarily imply that the respective stocks are the best investments. "We generally follow the principle of investing in undervalued stocks, [as do] the likes of Warren Buffet," says Shakeel Sarwar, head of asset management at Sico, Bahrain. "Even if a stock is not attractive in terms of dividend yield, it may be trading at a steep discount to fair value. Therefore, its potential return is very high." However, in an environment of uncertainty, like the current one when the potential for price appreciation is low, dividend plays present an opportunity to earn a decent return.

Retail investors favour companies that generate cash and have steady income that they can use to keep on paying dividends. But, Samer Darwiche, an associate at Gulfmena Investments, cautions investors that if a company is paying out dividends from cash reserves or from selling off assets, that can be a very dangerous omen. This indicates the company is shrinking.

A fundamentally strong company paying out high dividends is one which is making more profits each quarter to pay for it, he explains. Companies should only be paying out dividends if the don't have debt to service or investments where the returns are higher than the cost of capital, says Sarwar.

"Otherwise they'll be destroying shareholder value," he explained. "There are a large number of companies in the Gulf where, in absence of significant reinvestment needs, they can afford to pay rich dividends," he adds.

Darwiche says companies that achieve high net income growth, but pay low dividend yields, will be penalised by retail investors. But, in the case of companies with debt repayment needs and cash flow difficulties, investors should refrain from demanding dividends. "Core shareholders and management must keep an eye on the company's survival and focus on core business operations to meet obligations," he explains.

Opinion is divided on bonus shares, which many companies announce during the dividends season.

According to Sarwar, bonus shares (stock dividends) are worthless, as there's no cash return to shareholders. "In case of a bonus issue, the shareholders' wealth remains the same," he says.

"Although investors get more shares, the value of shares that they already hold gets diluted. Some companies issue bonus shares to reduce the value per share through dilution. This way shares can be made more attractive to retail investors. In addition they do it to appease investors who are unaware of the fundamentals."

Retail Investors in the region like bonus shares since it brings the market price per share to a more reasonable range and promote more active trading in the stock, argues Darwiche.