Where to find income in emerging markets

If your aim is to get a decent income from your stock portfolio, emerging markets (EMs) aren't the obvious place to look. After all, everyone knows that EMs are a growth investment a bet that these economies will carry on developing successfully and expanding their middle class of new consumers. There are no dividends to be found in Asia or South America; all corporate profits need to be ploughed back into new investments.

At least, that's the most common view of how EMs fit into an income strategy they simply don't. But it's completely wrong. While many EM companies don't pay dividends, there are plenty that do. And these companies can bring a lot to your income portfolio, as a small number of investors and funds are realising. With careful selection, it's possible to find firms that offer yields of around 5% and good growth prospects on top of that.

First, let's dispel the myth about EMs not paying dividends. In fact, dividends make a major contribution to EM performance, accounting for 30% of returns in Asia ex-Japan over the last decade. Yes, it's true that some EMs offer little in the way of income. For example, India's Sensex benchmark has a yield of just 1.3%, while South Korea's infamously shareholder-unfriendly firms are even worse, with the Kospi index on a yield of 1.2% and paying out less than 20% of earnings.

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But for every low-income market like this, there are many where a dividend culture is well established. For example, Thailand has an average yield of 3.5%, while Taiwan yields 3%. Brazil yields 3.4% and firms are obliged to pay out at least 25% of earnings as dividends. Singapore isn't technically an EM, but tends to get classed with them because it's so closely linked to its developing neighbours; its yield of 2.7% compares well to the 1.8% you'd get on the S&P 500 or the 2.04% available in Japan. Of course, you can get similar yields from the FTSE (3%) and from many European indices if you want to diversify internationally. So why is it worth going further afield?

Emerging dividends are growing fast

There are two obvious reasons. First, EMs offer not just an income but a growing one. With income investing, your long-term return depends not just on the dividend yield you start with, but also on the way those dividends grow in subsequent years. While the link between growth and stockmarket returns is not straightforward, it seems likely that dividend growth in EMs will be faster than in the developed world in the years ahead. Certainly, dividends for the MSCI Emerging Markets Index have grown by 57% over the last five years, against 19% for the developed-country-dominated MSCI World benchmark, according to Bloomberg data.

One of the attractive things about EMs is that it's possible to find promising companies with good growth prospects that are paying dividends from an early stage. This is in sharp contrast to the attitude in many developed markets, where the idea that firms should pay dividends while growing rapidly is very much in a minority. Indeed, in some growth sectors such as technology, many large and established businesses have yet to establish a dividend.

This may well reflect the fact that in EMs, many businesses are controlled by a founder or family. While the existence of a controlling shareholder can lead to minority shareholders' rights being trampled on, it also means that in a well-run firm the interests of management and the minority shareholders are aligned; both appreciate receiving a steady income from their investment.

Perhaps for the same reason, the curse of share buy-backs has yet to take root in EMs to the same extent as in much of the developed world. In the US and to a lesser extent Britain and Europe, the idea of distributing excess earnings by buying up shares has replaced the idea of solid and rising dividends for many firms.

Buy-backs appeal to executives with stock options since they can boost the value of the firm's shares and so increase the value of their options. But for long-term investors who would prefer a steady income, buy-backs are inefficient at best. At worst, they're wasteful, since firms have a bad habit of increasing buy-backs when their shares are expensive and stopping them when they're cheap. Good manager-owners with a long-term stake in the business are less likely to indulge in this kind of value destruction.

Emerging currencies should rise

The second reason for developed-world investors to look to EM income is that they can also hope to benefit from currency effects. If EM currencies rise against sterling, the dividends received from these investments will be worth more in sterling terms. Of course, this is not a one-way bet. In the short term, currencies can be highly volatile. But over the long run, it seems likely that the currencies of successful developing countries will rise against Western ones. This is especially true with the many Asian developing countries that still hold down the value of their currencies to improve export competitiveness. So having a balance between developed and emerging economies in your portfolio is useful if you want to ensure your income stream holds its value in global terms over the long run.

Diversify your risk with EM dividends

It's important to be aware of the risks, of course. It's dangerous to generalise too much about emerging economies, but as a rule they carry greater risks than developed ones. Governance standards are lower, so it's vital to look at the quality of the firm as well as the size of the yield.

Markets tend to be more volatile and, perhaps most importantly for the income investor, dividends can be as well. While many developed-world firms aim to increase the dividend steadily each year, many EM firms aim to pay out a certain percentage of earnings. As a result, dividends may vary more than Western investors are used to, depending on how well the firm is doing. The plus side of this is that the investor benefits from good results even if the shares fail to rise; the downside is that it makes your income stream that bit less predictable.

There are some very good-quality EM firms, but few are as tested and established as some of the blue-chip dividend stocks that you might go for when building a developed-world dividend portfolio. There's no doubt top-quality developedworld firms, which we regularly tip here in MoneyWeek, should still be the core of an investor's income portfolio.

But adding EM income on top of developed stocks could actually help make your overall income portfolio safer. In some developed markets, the popularity of buy-backs combined with problems in traditional dividend stocks such as banks, for example, means that the income-stock universe is becoming alarmingly concentrated. Just five UK firms account for 40% of dividend payouts and youjust need to look at what happened to BP shareholders in the wake of the Gulf of Mexico disaster to see how dangerous it can be to depend too much on any one stock for your income. Meanwhile, in Asia a far healthier 35 companies account for 50% of payouts, according to Invesco Perpetual data. So EM income could be a helpful way to diversify a portfolio among a larger number of divided payers.

At the same time, thinking about income as well as growth can help to make any EM portfolio safer. Good dividends are not necessarily the sign of a well-managed company, but a firm's dividend policy can certainly tell you something about the management's attitude. If a company is well placed and stable but refuses to pay out some excess cash as dividends, it may be a sign that the management team is not concerned about rewarding minority shareholders something that's very evident in low-dividend corporate cultures such as South Korea, but has improved noticeably in other parts of Asia over the last decade.

For this reason, you'll find that quite a few EM fund managers will admit that some of their portfolio choices are driven by attractive income rather than growth prospects, regardless of whether the average investor thinks of EMs as a growth bet. The number of dedicated EM income funds is still relatively small, but it is a growing sector with a number of recent launches. Below, we take a look at a few possibilities and also profile some promising income stocks for those who want to build their own portfolio.

What to buy now

Most emerging-market income funds available in Britain are focused on Asia, with the best known probably being the open-ended Newton Asian Income Fund. Like most Asian income funds, this has a substantial weighting in Australia (around 20%) which, of course, is not an EM but the rest of the portfolio is well diversified around most of Asia. Financials are the largest sector at around 30% and around 17% is in telecoms; both sectors are stalwarts of most income funds, since they are typically good dividend payers. The trailing yield is 5% and the total expense ratio (TER) is 1.66%; this includes an annual management charge of 1.5% that can be cut to 1% by using discount broker Cavendish Online, or 1.3% using Hargreaves Lansdown.

If you'd prefer an investment trust, there's the Henderson Far East Income (LSE: HFEL), which is similarly weighted towards financials and telecoms. The trailing yield is around 4.4% and it had a TER of 1.23% last year. Another is the Aberdeen Asian Income fund (LSE: AAIF); it has a lower yield of 3.7% and a TER of 1.4%, but perhaps a higher-quality portfolio. It has major weightings in Singapore (22%), including Singaporean banks OCBC and UOB, and Malaysia (16%), via stocks such as telecom group DiGi and a local subsidiary of British American Tobacco. Both funds tend to trade at a small premium to net asset value (NAV), meaning the usual advantage of investment trusts over open-ended funds the ability to buy assets at a discount doesn't apply.

Wider EM income funds are thin on the ground, although a couple launched last year. Perhaps the most interesting is the Somerset Emerging Dividend Growth Fund from boutique Somerset Capital Management (tel: 020-7499 1815). This fund has substantial weightings in markets such as South Africa (16%), Brazil (14%) and Turkey (6%), as well as Asia. The sector breakdown is also very different, with around 20% in technology and 19% in consumer staples. Telecoms account for 18%, but financials for just 7%. The anticipated divided yield is around 3.8% and the annual management charge is 1%; due to the short time the fund has been running, no TER is yet quoted. It's a small fund with £20m under management so far, but well worth a look.

The main investment trust alternative is another recent launch, the JP Morgan Global Emerging Markets Income Trust (LSE: JEMI). It's more weighted towards Asia, with Taiwan being the largest holding at 15%, although Brazil (12%) and South Africa (11%) are also significant. Financials, technology and telecoms are the largest sectors at 15%-20% each. It has an estimated yield of 3.5% and an annual management charge of 1%; no TER is yet available. It trades on a slight premium to NAV.

If you're looking for ideas to build your own portfolio, the tech sector in Taiwan may be a good place to start. Many Taiwanese firms only began paying dividends in the mid-2000s but now offer decent yields, and so are cropping up more and more in income funds. A top holding for many is Taiwan Semiconductor Manufacturing Company (TT: 2330, US: TSM). This firm is the world's largest independent semiconductor foundry it makes chips for design firms such as Qualcomm that don't have their own manufacturing facilities. A well-run market leader, its yield of 4.1% and growth prospects make it attractive.

Telecoms are a staple of income funds, but when it comes to emerging income, it's important to focus on more mature markets; rapidly growing ones such as India tend to suffer from high competition, price wars and huge investment needs. Markets that tend towards monopoly are better for income investors, as incumbents will have more spare cash for dividends. One fund favourite is Philippines Long Distance Telecom (PM: TEL, US: PHI), on a 6.5% yield. It recently agreed a deal to buy out rival Digitel, which would take its fixed-line market share to more than 50% and its mobile share to 70%.

Brazil's Cielo (BR: CIEL3, US: CIOXY) is an interesting financial services play and a top holding in Somerset Capital's fund. The firm is the largest credit- and debit-card processing network in Brazil, with a market share of around 50%. Competition in the area is picking up due to recent deregulation, but a fast-growing credit-card market should keep Cielo's 8.4% dividend fairly safe.

Mining is a boom and bust business, so lacks the earnings stability that ensures stable dividends. But if you're bullish that demand from EMs will keep commodity prices high, look at South Africa's Kumba Iron Ore (ZA: KIO, US: KIROY). It's a listedsubsidiary of mining giant Anglo American that was spun off to comply with the country's Black Economic Empowerment laws. It produced 43 million tonnes (Mt) of iron ore last year. This is likely to rise to 53Mt by 2013 and 70Mt by 2019. So if ore prices remain strong, its 7.5% dividend yield should also improve.

Singaporean real estate investment trusts (Reits) have drawn a lot of foreign interest in recent years after many quality stocks hit high double-digit yields during the worst of the global crisis in 2008-2009. We've tipped them regularly since then, and while you won't get those kinds of yields anymore, one that still appeals is Singapore-listed First Reit (SP: FIRT). It's a relatively small healthcare Reit whose main assets are Indonesian hospitals run by the Lippo Group, a local conglomerate. It's expected to yield 8.6% this year and this will probably rise over time as new developments in Lippo's pipeline are injected into the Reit.

Disclosure: The writer holds shares in First Reit.