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By Josh Peters, CFA and Jeremy Glaser | 10-29-2013 12:00 AM

Navigate Foreign Waters Carefully When Seeking Dividends

Investors shouldn't rule out foreign dividend payers but need to hold them to the same yield, risk, and growth standards as they would for U.S.-based stocks, says DividendInvestor editor Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Should investors be interested in foreign dividends? I'm here with Josh Peters, the editor of Morningstar DividendInvestor and also our director of equity income strategy, to take a closer look.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start by looking at some of the advantages of looking abroad for dividends. This is a strategy that's been growing in popularity over the last few years. Do you think that these stocks need a closer look?

Peters: I think that they're worth looking at, especially when you’re looking at ADRs or ADSs, American Depository Receipts or American Depository Shares. These are shares of foreign companies that trade directly on U.S. exchanges: New York Stock Exchange and Nasdaq. They're opening up a broader array of companies that a dividend investor, or for that matter any investor, has to pick from.

A lot of foreign markets have higher payout ratios and higher yields than the U.S. market, so it’s a way of potentially finding some higher-yielding stocks. And a lot of foreign companies will also get you more exposure to the global economy, or particularly, in emerging markets where companies have been earlier, say, European companies getting into emerging markets [earlier] than U.S. companies had.

So, there are some advantages associated with looking at foreign dividend-paying stocks.

Glaser:  Are there any drawbacks?

Peters: Yes. And it's easy to overlook some of the drawbacks once you start looking at foreign dividend-paying stocks, but it’s pretty important to keep some of these drawbacks in mind. First off, you go overseas. Not every company or every country is going to have a dividend policy that's similar to that of the United States.

In a lot of cases, the policies are more generous on average, but, say, in continental Europe, it’s very common for dividends only to be paid once a year as opposed to on a quarterly basis. And if a company has one rotten year for earnings, they may be more prone to just cut their dividend than an U.S. company would. There are just sort of cultural differences associated with dividend-payment practices.

Second, if you’re looking into emerging markets, I think dividends are a good tool to get emerging-markets exposure and help you find some of the better-quality companies, but the reverse is not necessarily true. I don’t think that emerging markets are the best place to get steady and consistently growing income from these more volatile markets. I think it's better perhaps if you’re more agnostic toward income to take advantage of dividends but not necessarily count on the predictable income from emerging markets.

Anywhere you go, you're going to probably have some currency risk. Dividends are typically denominated in the company’s home currency. So, if it's a British company, they're going to be paid in pounds. British companies are likely to either keep their dividend rate steady or raise them over time; that’s a cultural practice there. But if the pound has lost value against the dollar, then your income has been hit, even aside from whatever impact it’s had on the share price.

Then one big thing to be aware of, too, is that most countries withhold taxes on dividends that are paid to U.S. investors. It's pretty common for withholding rates to be in, say, 15% to 25% range.

If you’re counting on getting a large income return from a particular foreign stock, then you have to be aware of these taxes. Sometimes you can recoup them, in particular, in taxable accounts you can recoup up to 15% or 20%, depending on your tax bracket of the value of that dividend using the U.S. foreign tax credit on your Form 1040. But if the dividend is going into an IRA, there’s really no way to recoup that withholding tax. It's just a deadweight loss that effectively reduces your yield.

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