Dividends should not be the sole criteria for building a portfolio or selecting stocks. You can convert any stock into a high-dividend stock or convert any portfolio info a high income portfolio simply by selling a part of your position every year (or as often as you need) without having any net negative effect on your total net worth (value of stocks + cash) compared to a high-dividend portfolio. Here is how it works.
Stock price drops by amount of dividend on the ex-dividend date. Lets assume a high-dividend yield stock is trading at 100 rs on the last cum-dividend date and dividend per share is Rs 5. On ex-dividend date stock is suppose to open at 95 (assuming there is no other event that is causing the stock price to go up or down). Similarly, a low-dividend stock is also selling at 100 on last cum-dividend date and dividend per share is rs 1. This stock will open at 99 on ex-dividend date (again assuming there is no other event that is causing the stock price to go up or down).
On the ex-dividend date, your total net worth will be same rs 100 for both stocks (high-dividend yield stock will be worth 95 + 5 rs cash, low-dividend yield will be worth 99 + 1 rs cash). If you want a high dividend from the low-dividend stock, you can sell 4 rs worth of shares on the ex-dividend date (or any other date for that matter) and it will not have any impact on your net worth compared to when you buy a high dividend stock.
There is a common myth among investors that when stock price drops on ex-dividend date, it magically goes up sooner or later to whatever it was on the last cum-dividend date. That is not true. There is no reason why stock price should go up just because it dropped due to dividend payment. Stock price will up (or down) for all the normal reasons but dividend is not one of them, and it would have gone up (or down) irrespective of whether the company paid a dividend or not.
Practically, stock price tend to go up as the ex-dividend date approach, as investors buy the stock in anticipation of the dividend or in anticipation of the price rise before the dividend payment.Such stocks drop by a lot more than the dividend amount (sometimes even more than the earlier gains) after the ex-dividend date so there is no real benefit if you plan on holding the stock for long term.
Companies that have the ability to generate high return on capital and have the opportunity to do so, should really not pay high dividends. In fact, companies that do not have an opportunity to deploy profits at high rates, return the capital to shareholders in the form on dividends and buybacks. Such companies will not grow over long term. So high dividend payment is a signal from management that they do not see many opportunities to deploy the profits they are generating.
I would rather invest in companies that pay low dividends and have ability and opportunity to reinvest capital at high rates and if I want to generate high dividend from such position, I will sell a small fraction of my position regularly. If you do not want to decide when to sell, you can sell it on the ex-dividend date because it will have the exact same effect on your net worth had the company itself had paid a high dividend.
Essentially, this is converting part of capital gains into dividends. Govt will always to try to tax all sources of regular incomes at high rate and dividend is one of them. It will tax capital gains at a lower rate as investors take risk to earn it. So a high dividend portfolio is actually not tax efficient.
The only real benefit of companies that pay high dividend is that investors don’t have to do anything to get cash in their banks. Psychologically, selling a part of the portfolio to generate income is painful. It feels like you are consuming capital rather than income. Some friends have even told me that if you keep selling part of your shares regularly, there will be a point where shares will drop to 0 while if you spend only the dividends, then number of shares will remain unchanged. This is not true. Number of shares don’t matter,value of shares matters. When companies retain profits and have the ability to reinvest those profits at high return on capital, market will send the stock price higher, so even if you sell some shares regularly, total value of your position will still be higher than if the company had paid high dividends. As the price goes up, you will have to sell fewer and fewer shares to generate same amount of income. Moreover, if the company does well and its price goes up, there will always be bonus and splits so absolute share count will rise.
The real use of dividends is to judge quality of management and quality of earnings. When companies pay high dividends, its an assurance that company is actually earning the profits it says it is earning. High payout also mean that management is not hoarding cash (and likely to spend it unwisely in future) and is willing to share it with minority shareholders.
