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Seeking out the next generation of income

These days, emerging markets are home to some of the world’s most successful companies, says assistant portfolio manager CJ Cowan. Their growing maturity means that dividends could keep rising.

These days, emerging markets are home to some of the world’s most successful companies, says assistant portfolio manager CJ Cowan. Their growing maturity means that dividends could keep rising.

One of the most time-honoured approaches for income investors is to identify mature companies in well-established sectors as, all things being equal, they should be in a position to deliver the most reliable income streams.

Flushed with success

A good example is provided by boring old utilities stocks. Although they might lack glamour, they regularly take pole position in both the UK and US markets as the top yielding sector. This is thanks to the quasi-monopolies they enjoy and the heavily regulated industry structures they operate within that, in turn, enable them to extract high rents for what tends to be very consistent levels of demand.

Consequently, these companies are by their nature able to pay out a much higher proportion of their earnings as dividends. This can be seen from the dividend pay-out ratio for the US utilities sector, which currently stands at close to 80% compared to around 45% for the broader S&P index. 

Emerging wisdom

Given that high-yielding stocks will usually have a high dividend pay-out ratio, it’s not surprising that, until recently at least, income managers tended to steer clear of emerging markets when prospecting for income-generating stocks. This is because emerging market equities were historically labelled as growth assets rather than income-generating ones. And, ongoing growth requires the reinvestment of profits back into a company, which means less cash is available to be returned to its shareholders as dividends.

However, times change. These days, there are plenty of well-established emerging market-based companies that pay out appreciable dividends. As the chart shows, beneath the thrills and spills we tend to associate with them, the historic dividend yield on the MSCI Emerging Markets index has been consistently higher than that of the S&P 500 index for nearly a decade.

Of course, dividends alone don’t tell the whole story – especially when it comes to the US equity market where share buy-backs are part and parcel of equity investment. Last year, US companies spent over $1trn buying back their shares. Because they invariably cancel the shares once they’ve been bought, the practice naturally pushes up earnings per share (EPS) and valuations.

In the US, they’re seen as a more efficient way to return cash to shareholders and they’ve been a big part of the recent outperformance of the US market that we’ve seen in the current economic cycle.

 Dividend and conquer

Regardless of where they might come from, investing in higher quality companies that are expected to pay out stable or rising dividends, rather than more growth-oriented companies that rely on share price gains to deliver a return to investors, has a number of boons.