Once viewed as a source of growth, emerging markets now boast a burgeoning dividend culture that offers sustainable income to investors seeking to diversify their portfolios
While the economic case for increased emerging market exposure in portfolios is clear, many investors understandably remain cautious about the region’s volatility. With that in mind, the hunt is on for lower-risk routes into these markets and we see the region’s growing dividend story as key to this.
Demand for income is just as powerful a theme as growing Eastern economic dominance, with millions of baby boomers retiring with insufficient savings. In the UK, income funds have been a perennial favourite but most remain skewed to the home market and face ongoing concerns about yield concentration in a few large caps. Many are therefore looking to diversify their income-producing equity portfolio but few automatically turn to emerging markets for this, still seeing them as primarily a source of growth.
In recent years, this view has come to look increasingly outdated and ignores a burgeoning dividend culture. Much of this comes out of longer-term secular trends, with the region’s companies becoming more shareholder friendly in the face of greater global scrutiny. It alsohighlights a massive change in the global economic balance post-credit crunch, with crises now largely in the West and emerging markets stronger in terms of corporate, government and personal balance sheets. Improving corporate governance and management has led to falling debt levels and steadier cashflows, creating a platform for sustainable dividend payments.
With general share price weakness in recent years, dividend yields look extremely attractive across emerging markets as management teams increasingly come to understand the benefits of distributing excess cash to shareholders. Despite an improving dividend culture, we are still early in the story however and payout ratios are generally low compared with the West. That said, of the 800 or so stocks in the MSCI Emerging Markets index, over 700 currently pay a dividend and about 500 of these have increased their distribution for each of the last five years. Data from Morgan Stanley shows an average payout ratio of 32 per cent for the emerging world over the next two years and highlights substantial increases compared with a decade ago.
As a result, it is now possible to find emerging market companies across a range of sectors with dividend yields in excess of 5 per cent and build a compelling income portfolio in the region. All these factors mean a growing percentage of the total return generated by emerging market equities is from dividends and we expect this trend to continue over the coming years.
In contrast to the West, most emerging market businesses have also deleveraged and while widespread releveraging is unlikely, another stage of dividend growth can come from them sweating cash-rich balance sheets harder. Much of the concern about income strategies lies in dividend sustainability, particularly after many companies – especially on the banking side – were forced to cut or suspend payments during the credit crunch.
In the emerging world, the early stage of the dividend story is an advantage on this front, with very few companies yet to reach high payout ratios. Many mature western businesses have ratios as high as 90 per cent or even 100 per cent so a fall in earnings immediately impacts on dividend potential. In contrast, the lower payout levels among emerging companies means an earnings decline will not automatically feed through to dividends, although there have of course been some cuts and suspensions over the years.
As stated earlier, a frequent criticism of UK equity income funds is their concentration in a few large-cap names, with the top two income stocks (Shell and Vodafone) expected to account for almost a fifth of the total paid out in 2012. With so many emerging stocks now paying a dividend, a fund focusing on this area can have a much wider spread of industry exposure, although traditional income stalwarts such as telecoms and utilities still tend to dominate.
In our EM Dividend fund, these make up about 35 per cent, leaving 65 per cent diversified across the rest of the market. Financials is a large exposure but this includes areas such as insurers, brokers, Reits and asset managers rather than simply traditional banks. Of course, country diversification is another benefit, with 15 locations in our fund and none accounting for more than 15 per cent. Energy and materials are major sector underweights, with these companies generally capital consumptive and displaying the region’s worst corporate governance traits.
With such areas under-represented, our bias is towards domestic demand rather than exports, indicating another income advantage by focusing on the theme of growing Eastern economic dominance. Consensus suggests long-term emerging market growth will come from within rather than the region’s traditional exporting role and an income portfolio is naturally skewed towards more defensive domestic names and away from large international businesses in energy, material and technology.
Critics of the emerging market income story cite the fact these stocks have already performed well and claim investing now is too late. We would agree on the performance front but argue that our portfolio, on 10.8 times 2013 earnings with a 6.5 per cent dividend yield, does not look egregiously expensive. In the West, income managers have to focus on areas like tobacco, which are widely seen as ex-growth but offer the required steady cashflows; in contrast, emerging markets offer income from a wide variety of sectors and companies still able to post substantial future growth.
Julian Mayo is the co-chief investment officer at Charlemagne Capital