Go with the flows
Dividends really do pay off in emerging markets. Martin Steward asks why, and what the theories tell us about how far investors should tilt towards higher yields.
"Do you know the only thing that gives me pleasure?" said John D Rockefeller a century ago. "To see my dividends coming in."
Although not an emerging markets investor, Rockefeller was a growth investor, which makes his focus on dividends intriguing - especially given the recent launches of several ‘income' or ‘dividend' emerging market products. Among the managers IPE spoke to, EFG Asset Management (EFGAM) launched an Asia Pacific Equity Income fund in January 2011, ING Investment Management (INGIM) added emerging markets to its dividend equity range later that year, BNP Paribas Investment Partners (BNPPIP) launched its Emerging Markets High Income Equity fund in April 2012, Pictet rolled out its Emerging Markets High Dividend fund in May and JPMorgan Asset Management (JPMAM) launched an open-ended version of its Global Emerging Markets Income trust in July.
"It is counter-intuitive to look for income as the best way to capture the potential of emerging markets, but I very strongly feel that dividends and growth are not mutually exclusive in these markets," says Kathryn Langridge of Jupiter Asset Management - who "wishes" that her Global Emerging Markets fund was called an ‘Income' fund.
Dividends make up more than 50% of the total return from emerging market equities over the past decade and simply carving out the top-third highest-yielding stocks from the MSCI Emerging Markets index has outperformed significantly.
Many argue that this is because emerging markets are in a developmental sweet spot.
"There is still substantial growth to be accessed, but corporate governance is also improving, economies are diversifying, and companies are starting to pay out real dividends," suggests JLT Benefit Solutions senior consultant Alex Weiland, who has been looking at emerging-market income for his pension fund clients.
Nearly 750 MSCI Emerging Markets index companies now pay a dividend and more than 600 have done so for five consecutive years, but that does not really explain the outperformance of high yielders back to the mid-1990s, when less than one-third paid (much smaller) dividends. Moreover, this high-yield effect persists even in markets not known for yield; take the highest yielders in India or commodity stocks and you also outperform. There seems to be something fundamentally beneficial about dividends, even - or especially - in markets where income is least prized.
This basic truth was uncovered in US stocks in a 2003 paper by Cliff Asness and Rob Arnott, ‘Surprise! Higher Dividends = Higher Earnings Growth', which surmised that higher dividends might be a predictor of efficient capital allocation. "There's no doubt about that," says Michael Dillon, co-head of Asian equities at HSBC GAM. If management pays out 50% of earnings, it has to think very carefully about how it deploys the other 50%, agrees Manu Vandenbulck, senior investment manager at ING IM: "They cannot afford to be undisciplined and renege on their distribution policy."
Management used to focus on growing market share at all cost but, since the 1990s, leverage has fallen, capital is allocated much more efficiently, profitability has risen, and dividends can say a lot about how far a firm has travelled along this road. And Asness and Arnott were looking at the US market: if efficient capital allocation can generate alpha there, it's no wonder it has been so high in markets where interests are not so well aligned and numbers not so universally trusted. But the more critical this ‘quality' aspect of the return is, the less this income alpha would have to do with the simple fact of a high divided yield or high payout ratio, which can indicate the opposite of quality.
"By going for too much yield in the short term you can end up losing value or capital in real terms over the long term," says Edward Lam, lead manager on the Dividend Growth fund at Somerset Capital Management. "Stocks with high dividend yields might be ex-growth or even shrinking."
Most of our portfolio managers agree. Andreas Wendelken, manager of the Emerging Markets Top Dividend Plus strategy at DWS Investments, points to European banks in 2008 as the extreme example of yield dragging you into "value traps or companies with really fundamental problems".
Vandenbulck insists that companies in his portfolio are never valued according to yield alone. "Many companies in emerging markets don't have that discipline we look for - we see a lot of dividend cuts, for example," he explains. For the dangers of high payout ratios, he picks out Taiwan, a high-yielding market of very cyclical, global demand-dependent technology companies, whose earnings volatility can be very high: if a firm's payout ratio is 90% of earnings but those earnings can drop by 10%, clearly the yield its stock is showing is not sustainable.
"We prefer companies with a high dividend yield but with a fairly conservative payout ratio that enables them to weather dips in earnings - and gives them room to increase the dividend," agrees Stephen Burrows, co-portfolio manager of Pictet's Emerging Markets High Dividend fund.
This reflects these managers' emphasis on dividend growth rather than yield, which could help to make sense of why income gets rewarded in these growth markets. "Sustainable positive free cash flow enables management to blend investment in growth with returning cash to shareholders," says Langridge. "It's not about abandoning growth but identifying a stronger sub-set of companies that deliver that growth."
Indeed, Dillon argues that while you might want some high-yielding utilities for steady earnings, you don't want "very many". Instead, the "sweet spot" is a 3-6% yield with the prospect of sustainable above-inflation earnings and dividend growth. That would compound beautifully - but it also helps that it's not pie in the sky. While emerging market dividends grew by 17% per annum over the past 10 years, the average payout ratio remains a mere 30%.
Lam offers examples like South Africa's Shoprite, which has increased its dividend every year for a decade but still pays out only half its earnings, ploughing the other half into new stores across Africa. That kind of stock yields under 2% today, but if you bought three or four years ago your yield at cost is now more like 3%. By the same token, some of these managers like the yield desert that is Russia as they begin to see some movement from that exceptionally low base.
There are also catalysts for growth. Companies that have been maturing out of their most intensive capex phase but remain in a sales-growth phase have benefited from falling leverage and rising free cash flow. Debt-to-equity ratios in emerging markets sit at just 10-12% - China Mobile has over $50bn in cash. "A wall of cash is being built up that can eventually be distributed," says Gareth Maher, who manages Kleinwort Benson's nine-year-old KBI Dividend Plus Emerging Markets fund.
But hold on a minute. Figure 1 shows something much simpler than all that: dramatic outperformance from stocks that already have the highest yields and allegedly include a fair number of value traps. There is another theory to explain this which simply states that high yield means value, that value outperforms, and that it outperforms most markedly in growth markets.
Even some of our quality and growth-favouring managers articulate this intuition. "In a region awash with growth, it is looking at value and capital discipline that really differentiates one company from another," says Dillon. Maher says that dividend strategies work best in markets like the US or tech because investors tend to overpay for growth: "Similarly, investors are myopically focused on growth in emerging markets and forget that, ultimately, it all depends on valuations."
Maher's strategy systematically sells when a stock's yield falls below average, which he describes as a "value discipline". BNPIP's global head of high income equity Wouter Weijand also sells if a stock's yield falls below 3%. He worries if a company goes well past the 50% average payout ratio of his portfolio, but adds: "The growth trap is worse than the value trap in emerging markets".
But one manager is more straightforwardly value and yield-oriented. "Dividend yield is an outperforming strategy," says EFGAM portfolio manager Tony Jordan. "The figures are clear, there's no argument."
Jordan concedes that sustainability of dividends helps, but is "pretty convinced" that high yield outperforms because investors pay too much for growth. The fact that emerging market high-yield outperforms more than developed-market high-yield shows that it is not anti-growth, he argues - simply because these are growing economies.
Like Jupiter's Langridge, he feels that he is buying a better sub-set of growth; unlike Langridge, instead of higher quality, he thinks he is buying a cheaper sub-set and getting the profits before they are frittered away. "The evidence suggests you do better with high-yielders that have high payout ratios," he says. "Companies aren't managed by teams of Warren Buffetts - they don't always manage their cash wisely."
Is this just the age-old, value-versus-growth debate? Maybe so. But while no-one could mistake a German utility for a growth stock or a Norwegian oil services company for a value play, in emerging markets everything is growing (even a utility's customer base) and there's plenty of yield around (even from cyclical tech stocks), so it's expressed almost entirely bottom-up. The sector weightings of the S&P Global Emerging Markets Income Equity index are almost identical to those of the MSCI Emerging Markets index. Take out the underweights to Korea, Russia and India and the overweight in Taiwan and the country weights look pretty similar, too.
This confers real advantages. In developed markets, dividend strategies have to contend with compressed yields in the traditional defensive sectors thanks to the recent rotation into quality. The same rotation is evident in emerging markets - Asia's defensives are more expensive versus cyclicals than at any time since 1998, for example. But while consumer staples trades at a premium to its five-year average P/B ratio, it is the only emerging markets sector to do so. "Besides," as Burrows observes, "you can buy banking and insurance to access the consumer theme without paying too much."
Wendelken agrees that staples are expensive, but easily identifies opportunities among Malaysian infrastructure and telecoms stocks, domestic-oriented names in Brazil or mobile companies in Mexico. He emphasises that his DWS strategy invests in all countries and sectors: "We want to ensure that we aren't concentrated in Taiwan, Turkey or Mexico, or missing interesting stocks in India."
Maher at Kleinwort Benson stays "consciously industry-neutral", and claims to have seen some emerging market income funds with 35% in Taiwan, but insists he'd never have more than about 15%; Taiwan is actually a major underweight in Weijand's portfolio at ING IM. Dillon at HSBC GAM delineates not only cyclical-yield and defensive-yield stocks, but picks out defensive-yielders in cyclical sectors such as TSMC, Bangkok Bank, VTECH and Tatts Group, which enjoy fast-growing earnings and offer moderate, 2-6% yields.
At JPMAM, portfolio manager Claire Peck says that her portfolio has a core position of 60% in stocks yielding at least 4% and "natural overweights" in telecoms and utilities and countries like Taiwan, Turkey and South Africa.
The strategy goes off the beaten track to find fast-growing high-yielders with higher perceived risk of dividend cuts - like 8%-yielding Saudi fertilizer company SAFCO - but also holds Lukoil from low-yielding Russia and a major underweight in high-yielding financials. "This is not just a telecoms portfolio in disguise," she says. "Sectors associated with income in developed markets are not the same as you find in emerging markets."
It is perhaps not insignificant that many of these portfolio managers articulate what they do in similar terms to Langridge, who runs the strategy that she "wishes" was called ‘Income' but is not. "The natural assumption would be that you'd end up with a portfolio of telcos and utilities," she says. "But my fund does not have a particularly high exposure to them - precisely because I'm also trying to capture growth."
Likewise, Maher says he doesn't want "a portfolio full of telcos and utilities", and Burrows' prioritising of low earnings volatility does not preclude a top 10 that holds Taiwanese tech and Southern Copper, Gazprom, Kumba Iron Ore, Petrochina and Vale from the materials sector. "Those sectors do have more volatility, but that's why we like to find companies that have strong production growth and exposure
to demand growth in emerging economies, rather than cyclicals geared to the global economy," he explains. Langridge has low exposure to "very cyclical" Taiwan, but she does hold AngloAmerican, BHP Biliton and Vale. "It can be expensive not to be exposed to materials in emerging markets," she reasons. "But I'm still looking for companies able to throw off enough cash flow to maintain a decent stream of dividends."
These diversification strategies - supplementing true high-yielders with fast-growing, average-yield stocks or low payout ratios with dividend growth potential, rather than going for yield with conviction, puzzles Jordan, whose portfolio has nothing from India, very little from Korea, 17% in Taiwan and 40% in financials. "It doesn't seem like a strategy to me," he says. "That should be how you run a diversified portfolio, anyway."
Investors can have it all, and that is either the great advantage of a dividend strategy in the emerging world, or an ambiguity that can dilute the purity of the idea. Which one will depend upon what you believe are the key drivers of outperformance. It's not the easiest question to answer, but investors thinking about taking this contrarian approach to emerging markets should give it some consideration.