The case for equity income in the developing world
In developed stockmarkets, the power of investing in equities to generate an income is widely documented. The same, however, is also true of emerging markets.
Today, emerging market income funds represent less than 1.5 per cent of the total emerging market sector, compared with approximately 10 per cent in the UK and US, which suggests there is ample room for income investing to become a greater component of investors’ emerging market portfolios.
In our view, the case for income in emerging markets centres on the fact that the asset class offers an increasingly sustainable and stable source of income. Investors in stocks can’t purchase the fast economic growth of emerging markets directly. Instead, they buy into a stream of corporate earnings in emerging markets and, specifically, the dividends the relevant companies pay out.
In the past decade, the most impressive reforms with respect to financial instruments in the emerging world were arguably not the macroeconomic reforms we’re all familiar with, but the multi-year improvements in corporate discipline and governance, and the resulting improvement in operating efficiency and reduction in financial leverage.
It is these fundamental improvements that underpin the sustainability and growth of income from emerging markets. In the 1990s, emerging market equities were challenging for the bottom end of the league table in terms of return on equity (ROE) – the basic measure of profitability. Emerging market companies had too much debt on their balance sheets and prioritised gains in market share over profitability. The Asian crisis in the late 1990s was arguably a watershed for the management teams of many emerging market companies, teaching important lessons about capital discipline.
Over the next decade, emerging market companies shifted their focus to their core businesses. They moved away from trying to grab as big a share of their target markets as possible and concentrated on targeting profitability. They also placed a greater reliance on using their own cash to fund investment, rather than relying on financing from elsewhere. The result was lower debt and rising returns. Emerging market firms moved towards the levels of profitability found in developed markets, as well as towards the top of the corporate league table globally.
The opportunity presented by dividends in emerging markets is therefore dramatically different today than it was 10 years ago. But is this sustainable? The good news is that recent years have brought a significant economic challenge to test the robustness of this improving profitability and shift in management attitudes.
Emerging market companies have passed with flying colours. Corporate discipline and dividend policies are continuing to improve in certain countries. The shift to a more investor-friendly attitude to dividends in Russia is one of the best examples of this phenomenon –although admittedly the reason for this shift appears to be to boost the government’s income from state-controlled enterprises.