Richard Titherington, Chief Investment Officer, Emerging Market Equities, JP Morgan Asset Management
Whilst emerging markets are a highly volatile and highly cyclical asset class, they provide a compelling income opportunity, which is often overlooked by investors. We need only look at the divergence in total returns across EM countries this year to see evidence of the inherent volatility in the asset class.
In USD returns, Russia for example is down 30% YTD. Meanwhile, at the other end of the spectrum, Egypt, India and Indonesia are all up close to 30% in positive YTD USD total returns. The cyclicality characterising emerging markets can make for a bumpy ride, but importantly it also creates opportunities.
Investors who focus on companies that deliver sustainable income and are dividend oriented in their approach can somewhat mitigate this volatility. As we can see in the chart below, dividend per share growth of emerging market companies has outpaced developed markets even as emerging markets earning growth has disappointed on a relative basis. By prioritising income, investors can fish in a better quality pond of EM companies, those that choose to keep the interests of shareholders in mind.
In the yield-starved global landscape, emerging market dividend equities are cheaper relative to their developed market counterparts. High dividend yielding emerging market equities are trading well below their historical valuation average currently, whereas US and European high dividend stocks are well above average.
For investors concerned that the prospect of rising interest rates will derail an equity income based approach, consider that historical patterns show that there is actually a positive correlation between monthly stock returns and interest rate movements, when rates are rising from the low base we are currently at, as shown in the chart below.
Source: Source: Standard & Poor’s, US Treasury, MSCI, FactSet, JP Morgan Asset Management. Returns are based on price index only and do not include dividends. The “initial reaction” represents the period during which, in our judgment, markets began pricing the first rate hike through the date of the second rate hike. The “subsequent market reaction” is the period from the second rate hike to a point determined to be the end of the rate hiking cycle. The “total reaction” is the market movement across the full rate hiking cycle.
We think of the search for income in emerging markets as being divided into three categories:
1) High growth companies with a low dividend yield historically make up about 20% of our strategy, although currently that allocation is closer to 10%
2) The so-called ‘bread and butter’ component of the strategy is characterised by sound companies with a combination of sustainable, higher than average dividends and strong earnings growth
3) Higher yielding companies with little or no growth and heightened interest rate sensitivity
Looking across these categories, we have the ability to rotate exposures to various types of companies depending on the interest rate outlook. For example, we have brought down our relative weighting to the highest yielding equities, which function as bond proxies that are more sensitive to rate increases, and tilted towards more cyclical companies. Whilst cyclical companies do tend to be vulnerable to negative emerging markets sentiment, selective companies present compelling opportunities when we consider their attractive valuations.
As good example is the Turkish steel manufacturer ErDemir. Whilst the stock may seem high risk for an income orientated strategy, it projects high single digit dividend growth going forward and is a beneficiary of both falling oil prices and lessened competition from regions such as Ukraine and Russia.
In seeking EM income opportunities, we look for a combination of cheap currency valuations and strong dividend yields. Some examples currently include:
- Russian materials company Norilsk Nickel is the world’s largest and lowest cost nickel producer globally with a large reserve base. It’s currently yielding 7.7% and meeting its dividend targets. Their revenues are all generated in USD, meaning the company is a beneficiary of the significant falls in the ruble
- Taiwanese technology company Delta Electronics is an innovative industrial technology company and plug manufacturer. It falls squarely into the ‘bread and butter’ category cited above, having a 20 year history of cash dividend payments with a forward projection of low double digit dividend growth and current yield of 3.2%
- Ambev, the largest brewer in Latin America, is a stock that we’ve owned since inception of the strategy. With a 70% market share in Brazil, the world’s 2nd largest beer market, the company is well positioned for growth. They have a rising payout ratio and project high single digit earnings growth, with a currently yield of 3.9%. Ambev is also able to pass on currency weakness across various countries with rising prices, making them relatively more defensive against EM currency fluctuations