I have discussed why I use index-based investing for my portfolio and what index investing strategy I have adopted. In a nutshell, there are two reasons, viz., (1) It gives me a benchmark and floor to which I should compare my whole portfolio; and (2) I believe it tracks Indian economy. I presented my investing approach, which is different than SIP. The only reason I do not prefer SIP is because I do not want to mechanically buy at historically high prices. After posting those articles, I had a very good email conversation with Sachin, one of the readers of this blog. This conversation centered on investing approach. If I presented the conversation “as is”, then it would have very long and perhaps little confusing. Therefore, I am summarizing the gist of the conversation in two questions.
- Can we use dividend yield of the NIFTY index (instead of PE or PB)? e.g. DY > 2.1% invest 100%, DY >1.7 invest 80% and >1.2 invest 40%.
- My thoughts on split the monthly amount equally, one part to be invested as per relative PE, and second part as per absolute DY.
On the use of dividend yield of NIFTY index…
There is a school of thought that dividend yield is observable. And earnings (EPS) and book value (BV) are estimates or accounting calculations. To me, BV is misleading. The accounting BV that is available in financial statement masks many intangibles like company debt, its obligations, IP/copyrights/royalties, etc. So use of BV is not a correct metric.
Now, when it comes to DY and EPS they are both observable because we look into the past. It can surely be argued that DY is the hard cash that goes out of the company and EPS is calculated term. But when it comes to future estimates (based on past, like we do), both DY and EPS are the same situation. They are just estimates. However, the reasoning behind using EPS (instead of DY) is completely different.
Isn’t it surprising that I am an ardent fan of dividends, but when it comes of index investing, I do not use dividend (or dividend yields)? There are few reasons.
- The NIFTY index is a market capitalization based index (i.e. number of shares and market value only). It is not based on company fundamentals. So when the index itself is not focused on dividends, it does not make sense to use dividend yields for index. There could be a good company with good track record of earnings, but it may not pay dividends, or it has very low dividend payment. On the order hand, there are other good dividend paying companies which are not part of the NIFTY index. e.g. Nestle, Asian Paints, Gujarat Gas, Colgate, etc. Some of the best dividend payers are not even part of the index.
- If there is an index that is based on dividends, then yes, using DY makes sense. All companies in such an index will pay dividends. In India, we do not have dividend based index so far (I am not aware of it. Let me know, if there is one). In developed world, there are dividend-based indices which are very different than market-cap based indices.
- In the developed world, the motivation to use DY indexing is driven by a different objective. Indices based on DY (and dividend reinvestment) have provided much better returns over long one generational time frame. DY indexing is not for general capture of market performance or hedge against economic growth. DY indexing is to pick good companies which pay sustainable and growing dividends every year.
- Now, the earnings of the company is measured on per share basis i.e. EPS. Market capitalization uses number of shares as metric. We as investors would like to buy when the price is lower (i.e. price of per share – again a part of market capitalization). Therefore, I prefer to use PE ratio when it comes to index investing – what price am I willing to pay for a certain level of earnings.
On the use of split approach…
First, I do not like to use absolute metric whether it is a PE or DY. I prefer using a relative measure. It helps me weight it against history (and not against fundamentals). For relative measure, I compare with historical average. In my case, I use relative PE.
Second, I do not prefer combination of multiple small tweaks. Overall, whether it is DY-based or PE-based, I am trying to capture index performance. It is my belief that these two small tweaks will not provide any significant difference. My personal preference is to keep it simple, and hence use only one approach, whichever that may be.
I try to keep it simple by using widely preferred PE ratio. The only difference is, I buy more when index is historically cheaper (based on PE ratio) and buy less as it gets closer to historical average values. You may read some of my earlier posts on index investing.
Any thoughts and comments?
index, index investing, NIFTY, SENSEX