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.

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.

In the long-run, theory dictates that a company’s share price should reflect the earnings it’s expected to generate. But market sentiment has a profound effect on equity prices in the short term. 

Most fundamental equity analysts would hope to predict a company’s success over, say, one to three years, but trying to tie such predictions to short-term market gyrations can get a little messy. This is why so many equity houses have the tag line that they’re long-term investors; the hope is that these unpredictable market moves will even themselves out over a long enough time horizon. 

By contrast, dividends have a much more direct link to corporate earnings than current share prices. This is because earnings per share (EPS) x pay-out ratio = dividends per share (DPS). Consequently, the income paid out by a company as dividends should be a more predictable return driver than capital appreciation. Moreover, because of the stigma that attends a company that’s forced to cut its dividend, companies typically do everything they can to maintain their pay-outs, even if their earnings start to fall away.

Source: Quilter Investors/Bloomberg

Smoothing the ride

Focusing on high dividend paying stocks with stable earnings can also give investors a smoother ride. This is demonstrated by indices such as the Fidelity Emerging Markets Quality Income Index, which is a smart beta product that systematically allocates to higher-quality and higher-yielding stocks, weighting them to reduce stock specific risk. Over the past 10 years the annualised volatility of returns of the quality income index was 13.8% compared to 14.3% for the MSCI Emerging Markets index. And the total return was on average 2.5% higher each year so you were getting higher returns with less risk (albeit only slightly).

Another appealing trait of emerging market companies is that, with a comparatively low dividend pay-out ratio of 41%* for the MSCI Emerging Markets index – versus the 75%* offered by the UK’s FTSE 100 index – they also offer significant scope to ramp up their pay-out ratios.

With any such increase comes added investor interest from income seekers everywhere, which can also drive a pop in share prices. This is also why firms do their best to avoid cutting their dividends (as the same thing can happen in reverse). 

All this means that a focus on income-producing investments may be a way to lower the risk in your portfolio, while potentially enhancing return.

Even though the yield on emerging market equities might not be earth shattering right now, the risk and return profile that’s on offer from holding higher-yielding stocks in an asset class with significant potential for capital appreciation should surely be a strong candidate for every income investor’s portfolio.

*Source: Bloomberg as at 16 September 2019

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