EquitiesOct 30 2013

Balanced portfolio will pay dividends in EMs

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Chile’s fully funded state pension system is the envy of most governments in the developed world as they nervously eye their own pay-as-you-go pension time-bombs.

However, the prevailing view remains that investing in emerging markets is about tapping into the superior economic growth delivered by the demographic shifts of urbanisation, the wealth effects of a rising middle-class, or large-scale industrialisation supported by the cost advantages of cheaper labour.

But as the examples above show, these economies are increasingly mature, as are the companies operating within them. Given all of this, why should investors still be sceptical at the prospect of seeking dividend returns from emerging markets?

Of course the long-term drivers of growth remain important, and emerging economies are likely to outpace the rather feeble growth of their ‘developed’ neighbours for the foreseeable future.

But this focus on growth obscures the fact that one of the strongest trends for investors in these markets is a fast-developing dividend culture, something that it is unwise to ignore.

Growth and dividends are intertwined in emerging markets. As an investor, you do not have to forgo one to access the other. Simply put, stronger economic growth should translate to faster growth in corporate earnings, which with a stable dividend payout ratio, should see commensurate increases in dividends per share.

Companies in emerging markets frequently pay out a proportion of earnings rather than targeting a specific amount per share, so superior earnings growth is immediately reflected in the dividends. Statistical evidence shows there is a much stronger correlation between earnings growth and dividend growth in EM than DM.

This already attractive picture misses one of the most interesting aspects of the EM dividend story; that payout ratios are rising, largely because of improvements in corporate balance sheets.

Since the emerging markets crises in the late 1990s, company bosses have generally run their balance sheets fairly conservatively. Governments have mostly done the same – which is why I think the withdrawal of quantitative easing is unlikely to spark another EM crisis, although that is a subject for another article. The reasonable shape of company balance sheets in EM not only means that businesses are able to pay healthy dividends but that they are incentivised to do so, to avoid declining returns on equity.

Other factors are also encouraging the increase of payout ratios. As a relatively high proportion of EM-listed companies retain some degree of state ownership or control, increasing dividend payouts is one way of boosting cash-flows back to the government.

For example, Russia is pressuring companies to increase dividends to 35 per cent of earnings, while Brazilian corporation law requires a minimum ratio of 25 per cent. India, too, has asked state-owned companies to increase payouts.

As a consequence, emerging markets have delivered the fastest dividend growth of any region over the past decade or so.

There are two basic statistics that often surprise. First, the dividend yield on emerging markets equities is already comparable with that of developed markets, and is well above the yield delivered by either the US or Japan.

Secondly, a higher proportion of emerging markets companies pay dividends than their DM counterparts. This is important because it allows us to build a portfolio that is well diversified across countries and sectors, and does not force a concentration in particular areas such as utilities and telecoms that are more traditionally associated with high dividends.

The case for dividend investing in emerging markets is growing ever stronger. However, it is a strategy that has already proved its worth. Dividends represent a significant proportion of emerging markets total returns. Simple back-tests show that higher yielding stocks in the EM universe have outperformed lower yielding stocks over many years.

While value investing styles overlap with dividend styles rather than being interchangeable with them, similar results can be seen from analysis of ‘value’ versus ‘growth’ in emerging markets.

In a region that can be prone to large swings in both fundamentals and sentiment, a focus on dividends has a smoothing effect on volatility, offering welcome downside protection for EM investors.

While a reliance just on dividends is no substitute for in-depth research on potential investments, the fact that a company has got to the stage of maturity where it is able to return real cash to shareholders means that it is less likely to collapse overnight, or in a worst case actually be fraudulent. It is perhaps not a coincidence that Sino-Forest never paid a dividend.

In common with dividend investing in developed markets, I believe that a fundamental and research-led approach is essential. Simply selecting the highest dividend yields is unlikely to produce an outperforming portfolio as high yields are often a signal that the current dividend is unsustainable.

Evidence suggests the best-performing EM stocks tend to be those with moderate yields of 3 per cent to 4 per cent – in other words healthy companies generating solid cash flows, returning a proportion to shareholders while re-investing the rest in future growth.

It is not an easy task to identify these companies while insisting that they also meet the criteria of being attractively valued, and it is this painstaking process of research and analysis that occupies the majority of our time as portfolio managers and equity analysts.

In a region often perceived to be largely about ‘top-down’ investment styles, more than half the long-run returns from emerging markets can be explained by company-specific, rather than macro, factors.

With hindsight, the success to date of EM dividend strategies may be partly explained by investors’ search for yield in a low-interest rate world. Indeed, prior to Ben Bernanke’s speech in May this year, where the idea of ‘tapering’ QE was first introduced, there were even concerns of a bubble developing in EM dividend stocks.

The world has changed and investors are now worried about the relevance of EM dividend funds in an environment of rising rates. This is a complex issue as the outcome depends on what the market is trying to discount by selling down government bonds.

The normalisation of interest rates as the global economy returns to trend growth has very different consequences to a situation where rates are ramped to fend off an inflation problem.

But inflation is unlikely to be an issue, and the most probable outcome – deflation – would lead to victory for dividend styles, albeit a pyrrhic one.

In the most likely rising rates scenario of a gradual global recovery, so-called ‘bond-proxy’ equities – held by investors for no other reason than the carry trade provided by their high dividend yields – may indeed suffer.

Some countries, especially those with wide current account or dual deficits, may see currency weakness erode returns for investors based in ‘hard-currency’.

However, prospects remain good for high-quality companies able to steadily grow earnings and cash flows and with the capital discipline to return a proportion of these profits back to shareholders, along with ‘value’ companies that for various reasons have been overlooked by the market.

We would expect a portfolio comprising of a combination of these to continue to outperform the market over the medium term.

Robert Davis is senior investment manager of the Emerging Markets High Dividend Equity Fund at ING Investment Management