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The Case for Dividends in Emerging Markets

If you believe in the developing world's growth story, dividend-paying stocks might be the best way to capitalize on it.

Samuel Lee, 10/08/2011

The emerging-markets story is all about growth, the red-hot kind. Paradoxically, the best way to benefit from economic growth may be to hold boring, dividend-paying stocks. Compared with the rich world, emerging markets have weaker rule of law, feeble protection for minority shareholders, and poorer management—all factors that have fed into relatively poor stock market returns for fast-growing economies in the past. Holding dividend-payers is one of the few ways individual investors can mitigate these issues.

None of this matters, of course, if the market has already priced in the benefits of dividends. Fortunately, the “dividend bonus” may be undervalued thanks to the relative dearth of smart money in emerging markets and the difficulty of arbitrage.
Before we delve into the case for dividends in emerging markets, it’s worth visiting why dividends are good in general.

King Dividend
London Business School professors Elroy Dimson, Paul Marsh, and Mike Staunton have assembled one of the most comprehensive databases of stock market returns, covering 1900 to the present. They’ve found that dividends accounted for the majority of stock market returns in every country they looked at. Of the 19 major countries in their database, Sweden’s yawn-worthy 1.77% dividend growth rate was the highest.

With dividends accounting for the lion’s share of past market returns worldwide, it’sno surprise then that Dimson, Marsh, and Staunton found that dividend-payershave outperformed nonpayers in almost every country studied, both on risk-adjustedand absolute measures. To rub salt in the wound of efficient-markets models, thehigh-yield stocks had a lower beta, or sensitivity to the market’s performance, than nonyielding stocks. Risk-based theories have to add ugly epicycles to explain away these findings. The simplest explanation is best: Investors and managers have tended to overprice growth.

Is It Different This Time?
Focusing on dividends seems stodgy and quaint when emerging-markets economies have been growing at a breakneck pace, with corporate profits coming along for the ride. Sure, emerging markets have experienced booms before, only to have major busts. But many argue that this time is different, that emerging markets will experience decades of high growth. Even if we accept this argument, we can’t assume they will offer higher equity returns. The link between stock market returns and GDP growth has historically been weak. University of Florida professor Jay Ritter found that, for the period of 1900 to 2002, real per capita GDP growth and real stockmarket returns for 16 countries had a negative 0.37 correlation (“Economic Growth and Equity Returns,” Pacific-Basin Finance Journal, August 2005). In other words, if you traveled back in time to 1900 and invested in the stock markets of the countries you knew were going to be the fastest growing over the next century, you would have under performed a strategy that did the exact opposite. It seems unintuitive that a bigger earnings pie doesn’t trickle down to current shareholders. Why has this been the case?

GDP and total earnings growth tend to track each other, in principle allowing earnings per share to grow as fast as GDP—assuming no new share issuances, no new enterprises. In reality, a growing economy sucks in capital from domestic savers and foreign investors. Factories are bought, old firms fail, and creative destruction takes its toll. Old shareholders are diluted away, which is why no stock market grew dividends by more than 2% annualized over the 20th century. Rob Arnott andWilliam Bernstein calculated that this dilution drag has led earnings-per-share growthto lag GDP growth in the United States by about 2 percentage points (“EarningsGrowth: The Two Percent Dilution,” Financial Analysts Journal, September/October 2003). A later study found that dilution drag in emerging markets was 7% annualized from 1990 to 2003. Using data for the MSCI Emerging Markets Index, I also found a 7% dilution drag from 2007 to 2011.

Dilution not only detracts from current shareholders’ returns, but also signals future poor performance. Shares issued in initial public offerings and seasoned equity offerings tend to have poor returns. IPOs’ poor returns are often attributed to overoptimistic investors paying too much for growth. Seasoned offerings’ poor returns may be related to manager incentives: Corporate executives may engage in self-serving empire building, or they may rationally engage in market-timing, issuing shares when they’re overvalued (and thus cheap capital from the firm’s perspective).
Dividend stocks, to no one’s surprise, don’t issue as many shares, being in the late stage of the corporate life cycle. In a market where accounting measures and manager quality are suspect, dividends are excellent constraints on managerial misbehavior and a powerful signal of profitability, both current and future.

It’s All About Information
Of course, a forward-looking argument for dividend stocks cannot stand on historicalevidence alone. Markets are smart and adaptive, and the factors that drove dividendstocks’ outperformance in the past may no longer exist. However, emerging marketsstill have significant structural barriers to efficient pricing and, therefore, are ripe hunting grounds for systemic mispricings.

The biggest impediment to efficient pricing is the relatively small share of institutional ownership of free-floating shares, leaving a lot of pricing up to retail investors. Admittedly, big banks and insiders hold huge blocks of shares, but they aren’t setting prices day to day. A 2010 working paper by Söhnke M. Bartram, John Griffin, and David Ng found that institutional ownership as a share of emerging-markets large-cap stocks averaged under 22% from January 2000 through March 2009 (“How Important Are Foreign Ownership Linkages for InternationalStock Returns?”). In comparison, over that same period institutions owned onaverage 97% of free-floating U.S. large-cap equity assets.

As a cross-check, I calculated the size of emerging-markets mutual funds and hedge funds. According to BarclayHedge, emerging-markets hedge funds had about $243.5 billion as of the second quarter of 2011. As of July 29, actively managedemerging-markets U.S. mutual funds had $211.8 billion in assets. Assuming 2 times leverage for hedge funds, the combined mutual fund and hedge fund assets as a share of the free-float-adjusted MSCI Emerging Markets Index was only about 17%, in broad agreement with Bartram, Griffin, and Ng’s results.

Even these figures may overstate smart money’s ability to keep prices efficient. Many emerging markets don’t allow short-selling, or the securities-lending markets that lubricate short-selling are immature. The restriction makes many arbitrage strategies more difficult, if not impossible.

Finally, the swift rise of previously unknown short-sellers like the firm Muddy Waters has cast doubt on whether traditional U.S.-based asset managers really know enough about emerging-markets firms. These small short-sellers have managed to destroy stock prices of U.S.-listed Chinese companies by highlighting evidence of possible fraud, often involving large discrepancies between financial statements filed in China and those filed in the United States and Canada. Fraud allegations clobbered the share price of Sino-Forest, once Canada’s largest public timber firm, costing John Paulson’s hedge fund—typical smart money—hundreds of millions of dollars. Whether the shortsellers were right doesn’t matter; their ability to move stock prices illustrates the uncertainty that informed traders face in assessing value with poor or incomplete information.

Valuation Spreads: A Mixed Bag
The paucity of smart money making stock-level bets may explain emerging markets’huge yield spreads. As of late August, the WisdomTree Emerging Markets Equity Income Index DEM yields 7%, about 4 percentage points higher than the MSCI Emerging Markets Index’s yield. Applying the same procedure to U.S. and developed-markets stocks shows an approximately 2-percentage point spread between the dividend- and the market-cap-weighted indexes. Many of the high-yielding emerging-markets stocks don’t seem distressed or even slow-growing; they have high earnings, book and sales growth, unlike dividend stocks in the U.S. and Europe.

On the other hand, dividend stocks aren’t trading at a price/book ratio discountto the market. Historically, a narrow valuation spread, or difference in P/B for a typical value stock compared with a typical growth stock, has predicted disappointing returns for value strategies. The relationship isn’t especially powerful, and dividend strategies are only partly related to P/B-dependent value strategies, but it suggests that over the medium term dividend stocks may be vulnerable to an expanding valuation spread.

With all that said, there’s no guarantee that emerging markets as a whole are screaming buys, because their profits are inflated by booming credit creation. But we’d be happy taking a contrarian, dividend-oriented stance on them for the long run.

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Samuel Lee is an ETF Analyst with Morningstar.
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