It’s the capital gain, not dividend, stupid!

It seems logical that even before thinking of buying any common stock, the first step is to see how money has been successfully made in the past.  —  Phil Fisher

MUMBAI: Kunal Bajpai was zapping through television channels, when something caught his eye. The Oil and Natural Gas Corporation had just declared an interim dividend of Rs 25 on each share. The television channel had called in an investment expert to analyse the situation.

“Public sector stocks remain a good buy because they will have to keep paying dividends to help the government lower its fiscal deficit,” the expert said. This statement set Bajpai thinking. “Did people actually buy shares for dividend payments?” he wondered.

Common sense told him they did not. The dividend yield of the Sensex as on December 27,2005 was 1.47%. What this clearly told him was that investors buy shares for capital gain rather than dividend payment.

He thought the more appropriate question to ask would be, “Market prices of which kind of stocks appreciate over a period of time to create wealth?”

A wealth creation study by Mumbai-based broking firm Motilal Oswal for 2000-2005 throws up a few very interesting trends.

The study points out “The foundation of wealth creation is in “buying businesses at a price substantially lower than their intrinsic value. The lower the market value is compared to the intrinsic value, the higher is the margin of safety”.

The study identified top 100 Wealth Creators for the period of 2000-2005 in the Indian stock market. These companies have added at least Rs 100 crore to their market capitalisation for the period of 2000-2005, after adjusting for dilution.

In the last five years, oil and gas, banks and metals have created the most wealth. The darling of the markets, information technology, was at the bottom of the heap, with only one company, Infosys, making it to the list of wealth creators.

What this clearly tells us is that “fad investing into Information Technology companies at extremely high valuations has clearly taken its toll”.

Another interesting insight that comes in is “size of the company in terms of market capitalisation has an inverse correlation with the speed of wealth creation”.

What this means in simple terms is that in order to lock in substantial gains, the trick is to invest into a stock, when its market capitalisation is still small. As the study points out “If you are looking for speedy wealth creation, you should pick companies with market cap of less than Rs 1,000 crore”.

On the other hand wealth creation is directly proportional to earnings growth. As the study points out, “higher the earnings growth, the faster the pace of wealth creation”.

Companies that are focused in their business activity have been better at creating wealth. In the list of top wealth creators only, 3% fall in the diversified category. This is the tenth edition of the survey, and this seems to be a consistent trend over the years. The survey expects this to continue in the days to come in as “very rarely do companies have several successful businesses under one umbrella”, it says. So diversification which may make sense at an individual level does not really work at the company level.

30 state-owned companies have made it to the list of the top 100 wealth creators and have managed to create 50.6% of the total wealth created. But the market still remains sceptical about the state owned companies. The price to earnings ratio of these companies stood at 8.6 vis a vis 14.3 for privately owned companies at the end of the study period.

What this means in simple terms is that state owned companies have still not completely been rewarded in terms of market capitalisation.

These companies are still to unleash their real potential and government controls seem to be holding them back.

The example is hypothetical