Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Omar Negyal, Fund Manager, JP Morgan Global Emerging Markets Income Trust discusses the dividend prospects across emerging markets.
Emerging markets continue to raise countless concerns for international investors, such as the China-led slowdown, which included a collapse in many commodity prices, weakness in emerging markets currencies and disappointing earnings. But these fears have also contributed to very cheap valuations: at 1.2 times price-to-book ratio on the MSCI emerging markets index, emerging markets prices are reaching near crisis territory, a level at which long-term investors have historically been rewarded for investing.
Cheap has gotten cheaper, yet we retain conviction and add to high quality names
The impact of volatile emerging markets currencies has been painful for the asset class, but we are beginning to see pockets of value. For investors willing to stomach the risk of emerging markets in hopes of experiencing the gains – after all, we’re talking about an asset classes that represents 85% of the world’s population and 50% of the world’s GDP – the presence of a dividend income stream can go some way to softening the risk profile. That’s because usually companies that pay a dividend tend to by definition be friendly to minority shareholders and be stewards of good corporate governance, making them inherently less risky than the broader market.
The companies we invest in show a return on equity of 16% at a strategy level, which is meaningfully higher than the index. They also have a reasonable level of corporate reinvestment after dividend payments, which gives us confidence that as the cycle improves these companies can show growth going forward.
China Remains an Uncertain Prospect
Our preferences have been holdings in South Africa and Taiwan, whilst we have mostly avoided China. These views are outputs of an investment process that focuses on bottom-up stock selection, as opposed to being macro views, but they are nevertheless illustrative of where we’re finding emerging markets dividend opportunities.
In Taiwan, we tend to see good free cash flow, robust dividend policies and solid company fundamentals supported by the country’s strong current account surplus, protecting it from currency vulnerability. In contrast, South Africa is enormously exposed to higher macro risks and as a result has been dragged down in 2015 by the declining South African Rand. Cheap has gotten cheaper, yet we retain conviction and we’ve actually continued to add to high quality names that we like, where we are seeing value.
Taking a bit of a deep dive in Taiwan, we are invested in Vanguard International Semiconductor Corp, a chip manufacturer with a defensible niche in manufacturing. They’ve been able to generate attractive returns on capital through the business cycle, mitigating any volatility in their dividend stream. Another great example is Taiwan Semiconductor ADR, one of our top holdings. It’s a genuinely innovative company, which is relatively rare in emerging markets. It’s shown an ability to grow earnings as well as to reinvest to maintain and then increase earnings per share. Company management has confidence in the future cash flows, boding well for the strength of the dividends.
Investors might be surprised to realise there is a strong history of dividend paying in Saudi Arabia and the Middle East. Stock markets were originated in some of these countries in order to pay out cash distributions, facilitating the transfer of oil wealth, so payments to shareholders are an entrenched practice. One interesting stock here is First Gulf Bank, a well-managed and well capitalised bank that is bucking the trend of dividend cuts across emerging markets and offers a continued high yield.
Long Term Investors: Consider Out of Favour Markets
Another contrarian area of investment opportunity is Brazil, which has been under enormous pressure. However, many investors overlook the fact that the Brazilian government has mandated companies pay out 25% of earnings in the form of dividends to shareholders. An example of an attractive stock is AmBev, which is aligned with the interest of its minority shareholders and offers a 5% dividend yield with the prospect for continued growth.
It may be easy for investors to forget or overlook in times of pessimism, but emerging market companies have a surprisingly strong legacy of dividend, in many cases with a proven ability to pay out even in tough times. Some of the tailwinds for unloved emerging markets are looking attractive, not least the valuations picture. With price to book ratios at such historically depressed levels, it may be time to have more optimism than pessimism. Just look at the underlying returns for some emerging markets companies – we can find in many cases 15% return on equity with strong balance sheets, able to withstand a tough macro environment.
As a true long-term investor, it is worth remembering that the dividend stream over time should be more reliable than the price appreciation. An income component to your emerging markets exposure provides a more conservative approach, which may be rewarding to long-term investors as the headwinds eventually start to clear from this asset class.
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