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Navigate Foreign Waters Carefully When Seeking Dividends

Josh Peters, CFA
Jeremy Glaser

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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Glaser: Your list of drawbacks seems to be a lot longer than the list of advantages. Do you see any foreign stocks that are able to really overcome those disadvantages that look attractive to you?

Peters: Yes. I have not ever ruled out foreign stocks. I just expect that they're going to meet the same kind of standards that I would hold any U.S. stock to, and right now of the 35 stocks that are members of the Builder and Harvest portfolios in DividendInvestor, six of them are based in foreign countries. All of them trade here in the United States. So, they are just as easy to buy as any other kind of stock. But I think it's telling that five of the six are based in the United Kingdom, and that market, in particular, is attractive, not just for its dividend policies--which companies tend to be pretty predictable and are very reluctant to reduce their dividends year-over-year--but the U.K. also has a tax treaty with the U.S. where there are no withholding taxes.

So, whatever a Unilever or a Glaxo pays out to its shareholders in London, that is the same what is paid out to the shareholders in New York. You have the currency conversion to consider, but other than that, it’s a pretty straightforward type of relationship. And a lot of those British companies were early entrants into emerging markets, Unilever, in particular.

Glaser:  Investors are looking for exposure to foreign markets and foreign consumers, but maybe are weary of foreign stocks. Do they have any options in the U.S.?

Peters: Yes, and that's one thing to keep in mind, too. I think the diversification benefit associated with investing in foreign markets has gone down over time. Global economies, and especially global financial markets, are more correlated, more closely linked together now than they have been, say, 20-30 years ago, when a lot of studies were generated, showing wonderful diversification benefits of international exposure. I think that’s lessened considerably in the past 20 years. But there are some opportunities in faster-growing emerging markets or perhaps say a recovery for the European economy, which has been delayed, but starting to look more attractive.

There are lots of ways that you can get that exposure without having to buy foreign stocks, though. Philip Morris International is a U.S. company that pays regular cash dividends in dollars, qualified tax treatment, no withholding of taxes or anything like that. But it’s 100% outside the United States. Lots of businesses, like a Coca-Cola, is very much an international business, a global business, getting exposure to lots of different markets outside the United States. And yet you benefit from owning a stock that's based in the United States, getting those predictable dividends, no tax issues or serious currency issues directly affecting your dividend. And being in the United States means you got all sort of these predictable things that we take for granted, securities regulation and oversight, that you don’t necessarily have especially in those emerging markets that are there to protect investors.

I think it’s important to consider the potential advantages of looking overseas, but in the end any stock that you buy, like I said earlier, should at least meet the same standards that you would apply to a U.S. stock with similar yield and growth characteristics and risk characteristics. And to the extent there [a foreign stock had] withholding taxes or currency issues that create additional risks or drags, then the [U.S.] stock should be that much more attractive.

So, think in terms of a company having to meet a hurdle rate in order to make it in to your portfolio. If a foreign company can meet the hurdle, great; if not, you certainly got lots of stocks given the size of our market that yield 3%, 4%, 5% even though the market yield overall in the United States is lower than the global average.

Glaser: Josh, thanks for joining me today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I’m Jeremy Glaser.

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