On a simple comparison of major market indices, it is easy to see why so few investment companies or trusts focus on the income generated from dividends in EM companies. As a headline comparison, the FTSE 100 and Eurostoxx 50 indices currently yield 4.1 per cent and 3.5 per cent, respectively, while the MSCI EM index yields just 2.5 per cent.
EM is typified by economies that are experiencing rapid growth, industrialisation and urbanisation
However, this simply reflects the gross generalisation inherent in such indices that are constructed on the basis of market capitalisation to serve a market of passive tracker funds. These indices skew emerging market investments towards the hottest sectors (currently tech companies such as Tencent), while ignoring the nuances of particular sectors that offer significantly higher yields for income-focused investors.
EM is typified by economies that are experiencing rapid growth, industrialisation and urbanisation. Investing in these markets gives investors exposure to higher growth rates than are typically available in developed economies. Most investors would recognise this as potential capital growth. But there is another, often overlooked, aspect of EM returns – dividend growth.
As with the developed world, the best dividend opportunities often lie within the sub-sectors and, in our experience, the infrastructure and utilities sub-sectors in particular. Listed infrastructure and utility companies typically have long-duration operational assets that generate sustainable cash flows and often pay sustainable and rising dividends. These infrastructure assets typically offer “GDP-plus” growth – the result of millions of people being lifted out of poverty into the middle class as the local economy develops.
The Indonesian who trades in his motorbike for a new car to travel to work using toll roads; the Brazilian who installs a new air-conditioning unit in his house, adding to overall electricity consumption; the Chinese family that takes its first trip abroad as tourists, flying from Shanghai Airport for the first time; this is not incremental growth, this is a step-change in consumption. It is the toll road concessionaire, the electricity company, and the airport operator that are the clear beneficiaries.
Infrastructure assets are the enablers of growth, but it is not just this quality that makes these assets attractive. When operational, these assets usually offer high operating leverage. Once toll booths are manned (and often subsequently automated) there is very limited additional cost related to additional traffic on the road; there is no additional servicing cost to a household using more electricity or gas. The additional income generated from increased consumption flows directly to the bottom line, improving the profits that are distributable to shareholders – and often on concessions that can last 30 years or more.
As with all asset classes, there are, of course, risks. Investment in these assets is reliant on the existence of good regulatory frameworks and an enforceable rule of law. As such, investors need to be vigilant. However, it is pleasing to see that such regulatory and legal frameworks are improving considerably in emerging markets. Over recent years these issues have been and continue to be tackled head on in countries such as China, Brazil and India, the three largest emerging markets.
Investors also need to be wary of the political cycles in these countries as new elections can introduce non-market friendly governments that seek to dilute concession terms or even to revoke them entirely through the forced nationalisation of an asset. Of course, no country is immune to such government involvement (as evidenced by the UK political parties' attack on energy sector pricing). However, thankfully expropriation is an extremely rare occurrence, even in emerging- and frontier-classified countries.
From an individual company standpoint, there are many risk factors that should be considered. Firstly, there are the assets themselves – the location, the market, the contractual obligations and the concession terms. An ideal company would have assets that are irreplaceable, essential and deliver returns that are fully inflation protected. For instance, an electricity network is unlikely to be replaced by an alternative means of distribution, but a toll road could be made partially redundant by a new route (for example, a bridge connecting two parts of a city), or an existing port superseded by a newer, more efficient port that is able to take larger vessels.
Secondly, there is management. High-quality management teams with a strong investment discipline and good corporate governance will invariably lead to better returns in the long run. This is especially the case in situations where companies are majority owned by the state or with conglomerates whose intentions may not be aligned with minority investors. A sudden investment by a company into unrelated industries or sectors is usually a red flag, whereas management teams that return excess capital to shareholders demonstrate a tangible returns-focused discipline. A clear dividend policy beyond the minimum local listing requirements offers investors improved transparency and stability.
An example of such investments that can consistently deliver double-digit ebitda growth can be seen in Romanian utility companies, where ebitda is earnings before interest, tax, depreciation and amortisation.
In 2014, the national gas transmission, electricity transmission, and oil pipeline companies traded on single-digit price/earnings ratio multiples with large net cash balance sheets and typically paid out double-digit yields.
Following pressure from investors, including Utilico Emerging Markets, these companies started paying out the excess cash reserves with additional special dividends, resulting in significant income flows. Over the past 12 months these investments have paid a historic normalised yield of 8.1 per cent to 12.5 per cent and 11.5 per cent to 16.6 per cent including special dividends.
At a time of heightened uncertainty, companies such as these should continue to deliver predictable and sustainable income streams – giving investors protection in a volatile world.