Emerging Market Equity: A Sustainable Source of Income and Growth
Emerging Market Equity: A Sustainable Source of Income and Growth As of December November 2014 31, 2013 Alison Shimada Portfolio Manager, Emerging Markets Equity Executive summary Dividend paying equities have offered superior returns with lower levels of risk historically across global equity markets Higher yielding equities in emerging markets offer investors exposure to high levels of growth and income; a unique investment opportunity Traditional bond investors are providing tailwinds to dividend yielding equities in emerging markets in the near to medium term Economic convergence between developed and emerging economies is encouraging improvements in corporate governance that will sustain yields in emerging markets in the long term Introduction The once overlooked dividend has received renewed interest in recent years. Investors have rediscovered the compelling risk-return attributes of the stocks that pay them. The focus of research on this topic has been primarily on developed market equities. In this paper, we present a case for investing in higher-yielding equities in emerging markets. Before we discuss emerging markets specifically, we can make some general observations regarding dividend yielding equities globally. Some of the most complete historical data available on the variance in performance among higher- and loweryielding stocks can be found in the Center for Research in Security Prices (CRSP) U.S. stock database. Figure 1 shows the cumulative total returns of four broad portfolios of U.S. stocks from July 1927 through December 2013, formed and rebalanced annually based solely on levels of dividend yield.1 The data reveal a strong direct relationship between total return and yield, producing vast differences in terminal value over long time horizons. Figure 1: Growth of $1 With Dividends Reinvested July 1927 through December 2013 $100,000 $10,803 $5,840 $2,123 $1,379 $10,000 $1,000 $100 $10 $1 $0 1927 1932 1937 1942 1947 1952 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013 High Dividend Yield Low Dividend Yield Source: Kenneth French Data Library, CRSP Medium Dividend Yield Non-Dividend Payers Not only have higher yielding portfolios produced higher total returns, they have demonstrated lower realized levels of volatility across a number of relative and absolute risk measures. Accompanying statistics for the U.S. equity portfolios are referenced in Figure 2 shown below. Figure 2: Performance Statistics – U.S. Equity 7/1927-12/2013 NonPayers Low Medium High Yield Yield Yield Risk Free Rate Market Annualized Return 8.69 9.23 10.51 11.30 3.49 9.77 Annualized Stnd. Dev. 30.17 19.79 17.96 20.08 0.88 18.79 Sharpe Ratio 0.17 0.29 0.39 0.39 0.00 0.33 Annualized Alpha -0.99 -0.35 2.78 5.69 - - Beta 1.48 1.01 0.92 0.96 - - Source: Kenneth French Data Library, CRSP The U.S. findings are not anomalous. A study conducted by Morgan Stanley Research produced similar results across several markets.3 The charts on the next page show the relative performance among equity portfolios formed based on quintiles of dividend yield across the United States, Europe, Japan, and emerging markets (quintile 1 is the highest yielding quintile). Each portfolio reveals a strong direct relationship between total return and dividend yield. Importantly, the relationship was strongest in emerging markets. Explanations of the total return-dividend yield relationship The strength of this relationship has generated several explanations in the academic research. Because dividend yield is a well-established style metric, discussions of the total return-dividend yield relationship are often framed in the broad context of value and growth investing. There is a healthy and long-running debate on whether higher relative returns on value stocks (generally higher dividend payers) primarily reflect a rational risk premium, or whether investors are influenced by irrational biases that cause them to systematically overprice growth stocks and underprice value stocks.4,5 We acknowledge the merits of both arguments, but we believe there is an important factor that is often lost within the debate; corporate governance. We argue later in this paper that corporate governance, particularly in emerging markets, is a critical factor in determining the quality of a company’s dividend policy and its return potential. Emerging market equities offer growth and income It is important to highlight another distinction about emerging economies. By definition, they experience higher secular growth rates than developed economies. Strong growth creates a very fertile environment for the profitable investment of capital. For this reason, it is intuitive that dividend payout ratios are relatively lower in emerging markets as companies 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% Figure 3b: Best relative performance in Europe comes from stocks with DY in quintiles 1 & 2 8.0 6.0 4.0 2.0 0.0 -2.0 -4.0 -6.0 -8.0 Q1 Q2 Q3 Q4 Q1 Q5 Figure 3c: Best relative performance in Japan comes from stocks with DY in quintile 1-2 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% Q1 Q2 Q3 Q4 Q5 Q2 Q3 Q4 Q5 Figure 3d: Best relative performance in EM comes from stocks with DY in quintile 1 Median 12m relative performance Median 12m relative performance Price multiples are generally lower in emerging markets, producing cheaper valuations with respect to book values, earnings, cash flows, and dividend levels (e.g., long-term average P/E multiples are nearly 20% less than the long-term world average).7 All other things equal, lower valuations result in elevated dividend yields (dividends/price). Thus, a key takeaway is that investors holding dividend paying stocks in emerging markets are rewarded through both strong growth and attractive dividend yield—a compelling combination that is difficult to find elsewhere. Median annual relative performance since 1997 (%) Median 12 relative performance Figure 3a: Best relative performance in U.S. comes from stocks with DY in quintile 2 steer profits into capital expenditures. The long-term average payout ratio of 35% in emerging markets is substantially below that of developed markets (i.e., 52% in Europe and 56% in the U.S.).6 Yet, with lower payout ratios in emerging markets, it seems counterintuitive that dividend yields are similar to or greater than those offered in developed markets. What is the explanation? 6% 4% 2% 0% -2% -4% -6% -8% Q1 Q2 Q3 Q4 Q5 Source for 3a-3d: FactSet, IBES, MSCI, Morgan Stanley Research WELLS CAPITAL MANAGEMENT 2 Investors are focused on yield Exposure to both growth and income is critical for generating superior total returns in emerging market equities. However, the income component of emerging market equities has attracted more attention lately, even from traditional bond investors who are failing to find suitable yields in global fixed income markets. In 2012, a record high $1.1 trillion in government and corporate debt was underwritten in emerging markets.8 Dividend yields in emerging market equities are now comparable to bond yields, generating spillover demand to the equity space. Several yield-focused equity products have been introduced to capture these so called “bond refugees.”9 A substantial portion of these offerings has taken the form of exchange traded products, with dividend-focused ETF issuance accelerating throughout 2012 and into 2013.10 While yield-focused flows have been and will likely continue to be a tailwind for emerging market equities in general, investors should be cautious of passive yield-based approaches that neglect proper diversification or scrutiny of company fundamentals. Common pitfalls are discussed below. Concentration risks Emerging market equity strategies that emphasize yield can favor elevated exposures to low growth sectors (i.e., utilities, telecoms), partially explaining the rich relative valuations in the crowded defensive sectors today (i.e., the “expensive defensives”).11 But as the chart below indicates, meaningful dividend yields can be found across sectors, including more attractively valued cyclical sectors. Figure 4: Emerging market equity dividends by sector MSCI EM Financials MSCI EM Energy MSCI EM T/cm Svs Figure 4 reveals another pitfall to making a naïve market allocation to dividend yield; over half of all dividends paid are generated by companies from only three sectors. This level of sector concentration introduces common factor risks to the portfolio. One need only look back to the 2008-2009 financial crisis to understand that heavy financial sector exposure decimated equity portfolios across global markets. Moreover, dividend yields can vary widely by country, making a naïve country allocation to yield a similarly dangerous exercise. Yield traps Even if investors avoid the portfolio level risks discussed above, they would be remiss to neglect the company-specific risks associated with very high yields. Dividends are paid from cash flows that are ultimately sustained by company earnings. If the market anticipates weakening earnings prospects and re-prices a stock, the resulting higher yield may simply portend a dividend cut. In a similar vein, if a payout ratio rises gradually over time or is too high for a company’s prospective earnings growth, this may reflect harvesting of the asset base, putting dividend sustainability at substantial risk in the longer term. While dividend increases represent a strong signal of management’s confidence in earnings sustainability, dividend cuts are usually accompanied by sudden, large capital losses for shareholders. This underscores the need for active, fundamental analysis to guide security selection. Some of the new product trends in the market may be subjecting investors to one or more of the above risks. We believe that both portfolio-level and security-level risks must be actively managed, particularly in light of the inherent transparency and transactional inefficiencies that still exist in emerging markets. Yet change is afoot. There are important developments that have quietly been reshaping the landscape in emerging economies for some time. Their cumulative effects will present a paradigm shift for how investors view emerging markets and, consequently, will change corporate management behaviors. MSCI EM Materials MSCI EM IT MSCI EM Cons Staples MSCI EM Cons Discr Trailing DY (%) MSCI EM Industrials MSCI EM Utilities % contribution to total market dividends (IBES FY1) MSCI EM Health Care 0.00 10.00 Source: IBES, MSCI, Morgan Stanley Research WELLS CAPITAL MANAGEMENT 20.00 30.00 40.00 Emerging economies are less emerging than before Emerging economies have traditionally been starved of capital investment. Capital-to-labor ratios have been low in comparison to those of developed economies, making marginal returns to 3 capital investment very high historically. Rapid industrialization has produced strong returns to capital in the past 26 years. The MSCI Emerging Markets Index has generated a 12.12% annualized return since its introduction in 1988, outperforming the MSCI World Index by 4.18% annually.12 But continuous capital investment has also brought the capital base in emerging economies into greater equilibrium with developed economies. The flood of capital into emerging markets recently has hastened this. Corporate management teams are increasingly recognizing these structural developments in their investment plans and their use of cash. Figure 5 illustrates how more companies in emerging markets are returning capital to shareholders. This presents a tailwind for dividend-focused investment approaches. In contrast, cheap labor is increasingly scarce. Chinese wages increased nearly 20% annually in the past decade!13 Competition has pressured labor costs, eroding profits to the point where relocation of certain labor-intensive industries to lower cost centers or frontier markets is prudent (e.g., moving textile factories from China to Cambodia).14 At the other end of the spectrum, multinationals in more capital-intensive industries are increasingly shifting some production back to developed economies as logistical and labor cost advantages decline. Thus, labor markets are also coming into greater equilibrium. A new focus on capital efficiency The structural changes outlined above will present challenges to old growth strategies and open up new growth strategies. For example, higher wages are producing rapid wealth accumulation among a burgeoning middle-class, creating strong growth opportunities in consumption-driven sectors. But the net effect of economic convergence is likely slower overall growth in emerging economies going forward. Figure 5:The rise of emerging market dividend payers (% of stocks paying dividends) 100 MSCI EM Yet some management teams cling to obsolete growth strategies. In the next section, we discuss some factors that may pressure some of these holdouts to change course. We are seeing evidence of overinvestment in emerging markets today which has, no doubt, been perpetuated by the wall of capital inflows discussed above. Capex-to-depreciation ratios are close to 200%—near all-time highs.15 Emerging market payout ratios are about 4% below their long-term average.16 Aggregate investment statistics do not differentiate between good and bad investment, but clearly there is evidence of strong overall expansion into a soft global growth environment. However, we believe there are forces at work that will support greater payouts in coming years. Figure 6: Borrowing capacity in emerging markets is high Net debt / equity (%) World 80 EM 70 60 50 40 MSCI DM 30 90 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 1999 70 2000 20 80 Source: CLSA Asia-Pacific Markets Increase in number of companies paying dividend within EM augurs well for future dividend contribution to total returns 60 50 Source: Factset, CLSA Asia-Pacific Markets WELLS CAPITAL MANAGEMENT 13A 12A 11A 10A 09A 08A 07A 06A 05A 04A 03A 02A 01A 00A 99A 98A 40 Figure 6 illustrates corporate deleveraging that has occurred steadily over the past decade. The cost of debt service has declined rapidly with central bank policy accommodation, and overall debt ratios are now conservative in emerging markets. Corporate bond markets in emerging economies have grown rapidly, providing a needed complement to bank financing. We expect debt ratios have ample room to increase in coming 4 years. Astute management teams can reduce their cost of capital, increase payouts to shareholders, and streamline the balance sheet. Balance sheet bloat has largely been the result of profits piling up as retained earnings. It is the misuse of retained earnings that should concern investors (i.e. allowing cash to idle on the balance sheet or making capital expenditures that do not earn their cost of capital). Slower global growth has brought both profit margins and revenues under pressure,17 particularly in industries that have global excess capacity (i.e., the old growth strategies). Additional investment in these areas destroys capital. management should have incentive packages that align with investors, including meaningful exposure to gains and losses. Ownership structure The quality and independence of the board of directors is also critical, particularly in environments with significant levels of cross-ownership, undisclosed owners, or government ownership, as is often the case in emerging markets. Careful attention should be paid to non-market incentives of other owners, and any special relationships between corporate management and the board. How dependent is the company on non-controlling shareholders? How have the property rights and objectives of minority shareholders been treated historically? Figure 7:The DuPont Model illustrates capital efficiency ROE Profit Margin Net Income/ Net Income/ Equity Sales = X Asset Turnover Sales/ Total Assets Leverage X Total Assets/ Equity The answer for management teams with bloated balance sheets is to return more cash to shareholders in the form of dividends or share buybacks. The evidence points to higher payouts and greater capital efficiency that will ultimately reward share prices. Payout is part and parcel of corporate governance The optimal payout ratio is company specific. There is room for well-run low growth or high growth firms to achieve superior returns. To do so consistently, corporate management must match dividend policy to rational levels of capex. This is easier said than done. Investors must assess not only the company’s lines of business and their competitive prospects, but also whether management is likely to make decisions in the best interests of shareholders. We believe that the most important indicator of optimal management behavior is corporate governance. Quality of management Quite simply, does the management team have the ability and incentive to make the right investment decisions and execute on them? Investors should look for education, level of experience, relevant work history, and a track record of business success that are comparable to world-class competition. Investors should measure the consistency and integrity of management communications to shareholders. Corporate WELLS CAPITAL MANAGEMENT Special considerations Corporate governance often reflects local market traditions. Investors may have traditionally demanded higher payouts as compensation for hyperinflation (i.e., Latin America). Institutional investors in Chile and South Africa have demanded income. Corporations in Brazil are required to pay out 25% of profits as dividends.18 Family-controlled companies may have a tradition of high payouts to maintain lifestyle. Are these traditions impacting the optimal management of the company? Functioning capital markets instill discipline We close with a final thought regarding our optimism for improved governance in the future. Major companies that operate in emerging economies must increasingly access global capital markets, encouraging, sometimes forcing, the adoption of certain developed market governance and reporting standards. Global standards trickle down to smaller competitors. This trend is part of the overall confluence between emerging and developed economies that we have highlighted above. The rewards to compliance are high, as cost of capital declines commensurately with disclosure and good governance practices—a very important motivator in the face of rapidly increasing global competition. For this reason, we are optimistic about governance trends and the return prospects available in emerging market equities going forward. Conclusion The outperformance of dividend paying stocks in developed markets, like the U.S., has long been recognized. More recently, investors are beginning to discover the advantages of dividend paying stocks in emerging markets. Investors have traditionally looked to emerging markets for growth, but payouts have 5 increased in recent years as emerging market economies mature and secular growth moderates. Today, emerging markets feature many companies with attractive prospects for growth and sustainable income—an exciting opportunity for total return investors. The highest yielding stocks in emerging markets have received heavy investor flows lately, subjecting some investors to low growth prospects, elevated concentration risks, and a lack of adequate issuer scrutiny. An active approach can mitigate these risks and identify those dividend paying companies with the most attractive growth opportunities. The outlook for higher payouts to shareholders is positive, as high corporate profits, low debt, and cheap credit have expanded balance sheet size and liquidity. The appropriate WELLS CAPITAL MANAGEMENT payout ratio is determined by market-imposed improvements in capital discipline and the quality of corporate governance. Increased payouts signal commitment to minority shareholders, proactive cash management, and management’s assessment of improved earnings prospects. As such, increased payouts reflect shareholder-friendly governance and are correlated with positive stock price performance. Total return income strategies in emerging markets have the potential to outperform across the business cycle, providing both income to dampen volatility and growth into an economic expansion. Opportunities are ample across sectors and countries. Total return investors in emerging market equities will likely benefit from the trends outlined in this paper well into the future. 6 Alison Shimada Portfolio Manager, Emerging Markets Equity Alison Shimada is a portfolio manager for the Emerging Markets Equity team at Wells Capital Management. She joined WellsCap in 2003 after serving as an investment officer of the University of California Regents-Office of the Treasurer. Prior to her current role, she served as a senior analyst covering areas of developing Europe and Africa for three years with the firm. She began her responsibilities at WellsCap as the head of equity research for the developed markets (EAFE) international equity team and as a senior investment analyst for Japan and Australia/ New Zealand. She began her investment industry career in 1985, and her prior experience also includes serving as a portfolio manager specializing in Malaysian equities at Commerce Asset Fund Managers and as a senior equity analyst covering Japanese securities at Fidelity Investments Japan. Alison earned a bachelor’s degree in political economies of industrial societies from the University of California at Berkeley. She earned a master’s degree in business administration from Harvard Business School. This paper significantly benefited from extensive research and development by Matt Alexander, CFA, product manager at Wells Capital Management.The author thanks him for his helpful comments and suggestions. The High, Medium, and Low yield portfolios represent the top 30%, middle 40%, and bottom 30% of dividend paying stocks formed on Dividends/Price at the end of each June using NYSE breakpoints. The dividend yield used to form portfolios in June of year t is the total dividends paid from July of t-1 to June of t per dollar of equity in June of t. The Non-Dividend Payers portfolio represents stocks with no reported dividend payment from July of t-1 to June of t. Portfolios are formed from all NYSE, AMEX, and NASDAQ stocks for which data are available. Data are courtesy of Kenneth French Data Library and the Center for Research in Security Prices (CRSP). 2 Market and Risk-Free Rate are derived from the Fama/French Factor Portfolios. 3 Morgan Stanley Research. U.S.: 6/1973 to 8/2014. Europe: 1/2001 to 7/2013. Japan: 1/2001 to 7/2013. Emerging Markets: 1/2001 to 7/2013. 4 Fama, Eugene F., and Kenneth R. French. 1992. “The Cross-Section of Expected Stock Returns.” Journal of Finance, vol. 47, no. 2 (June):427–465. 5 Lakonishok, Josef, Andrei Shleifer, and Robert W. Vishny.1994. “Contrarian Investment, Extrapolation, and Risk.” Journal of Finance, vol. 49, no. 5 (December):1541–78. 6 Morgan Stanley Research, 6/25/12 7 UBS Investment Research, 2/13 8 Fundfire, “Inst’l Emerging Debt Flows Risk Overheating,” 4/1/13 9 Citi Research, 2/6/13 10 UBS Investment Research, 2/13/13 11 CLSA Asia-Pacific Markets, 3/1/13 12 Through 12/31/12 13 Wall Street Journal, “China’s Changing Workforce,” 5/1/13 14 Financial Times, “Cambodia Benefits From Rising China Wages,” 1/7/13 15 UBS Investment Research 2/13/13 16 Morgan Stanley Research 6/25/12 17 UBS Investment Research, 1/24/13 1 CFA® and Chartered Financial Analyst ® are trademarks owned by the CFA Institute. Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000. WELLS CAPITAL MANAGEMENT® is a registered service mark of Wells Capital Management, Inc. WELLS CAPITAL MANAGEMENT 7
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