Does 8% tax-free return sound appealing?

We are living in times when return of capital is a bigger worry than return on capital. Needless to say, investors are willing to compromise on returns, to any extent, for safety of their capital. The poor economic and earnings outlook have got investors averse to the idea of investing in stocks. Bonds and fixed income instruments, which were mis-sold on the premise of safety, have also eroded investor wealth in recent months. Thus, there is hardly anything beyond bank fixed deposits that investors wish to park their hard earned money in.

Every now and then, we get investor queries asking why they should remain invested in equities. That most stocks will return less than FD interest rates over the next one year is a no brainer! Well then, should anything beyond fixed deposits even feature in the asset allocation for retail investors? Our answer to this would be absolutely yes! While fixed deposits can offer assured returns for short term, they can hardly cover for inflation over the long term. And gold, although a necessary hedge against inflation and currency risks, cannot be a major portion of one's portfolio. It is therefore important to remain invested in equities. More so, in such times when the dividend yields are making up for the lack of capital gains.

Take the case of PSU banks for instance. Most of them have been battered over the concerns of treasury losses and non performing assets. The fundamentals of these entities have certainly deteriorated over the past one year. Some have the worst behind them. Others are yet to see some pain. Markets therefore have discounted the valuations of these entities to such an extent that they are now more valuable dead than alive. That is, most of them are trading at 50% of their networth. Important to remember that the PSU banks together corner 60% of India's banking sector. And their future, although bumpy, is secured by government holding. Thus the dividend payouts of these entities too are guaranteed to a great extent. And at current prices, the generous payouts can fetch investors yields that are very close to FD interest rates. What is more, unlike FD interest rates, the yields can only go up as the payouts increase year after year. Also, that dividends unlike FD returns is tax free in the hands of the investor makes the case stronger for the former.

Now, this is not to say that investors should grab every PSU bank or other stocks offering mouth watering dividend yields. The risks that some of them carry can indeed wipe out portfolio returns. Also one must avoid getting carried away by the lure of dividends. The exposure to such stocks, if at all, should be keeping in mind their balance sheet and management quality.

Source: Equitymaster