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.
