Market Views: Equities
Rate cuts push case for Asian dividends
The widely anticipated cut in interest rates by the Federal Reserve (Fed) has finally arrived. While a minority of market participants were disappointed with the size of the cut, it should still be clear to most that the global policy easing cycle has now been firmly set in motion.
Even before this Fed rate cut, central banks in a number of countries had already started lowering their policy rates. At its May meeting, the central bank of Philippines cut its key overnight reverse repurchase facility rate by 25 basis points (bps). It marked the country’s first rate cut since May 2016. On 18 July, Bank of Korea reduced its seven-day repurchase rate to 1.5%, the same day that Bank Indonesia lowered its key interest rate by 25bps to 5.75%.
These moves came on the back of earlier rate cuts in New Zealand, Australia and India, as well as China’s reduction of its reserve requirement ratio (RRR). Meanwhile, both the European Central Bank and Bank of Japan have also signalled that fresh easing measures are on the cards.
Amidst global growth concerns, exacerbated by continuing China-US trade tensions and heightened political uncertainty in the Middle East, these rate cuts are welcome news for the market.
However, not everyone is happy. Declining interest rates present particular issues for institutional investors, such as pension funds and insurance companies. Because of the fundamental duration mismatch between their assets and liabilities, these investors are now faced with the massive challenge of generating sufficient returns to meet their guarantees to policyholders and pensioners. For them, the search for yield alternatives is now back on. It also means that Asian dividend-yielding stocks are back in focus again.
The long-term case for investing for dividends in Asia
Regardless of where interest rates are going, we would argue that dividend-yielding stocks should always form the basis of an investor’s Asian investment portfolio. This is because, despite the market’s obsession with share price appreciation, two-thirds of the long-run equity returns from the region have historically come from dividends. It would be foolish to ignore such a major component of total returns.
Higher dividends = higher earnings growth = better corporate governance
Critics often question the need to bother with boring dividends in a vibrant place like Asia. Finance 101 has already taught us that only companies which have run out of growth opportunities pay dividends. Why buy slow-growing, dull dividend-yielders when investing in a dynamic region boasting strong future economic growth underpinned by the structural trends of urbanisation, industrialisation, rising middle-income consumption and positive demographics?
Contrary to these beliefs, companies paying high dividends are neither low-growth nor boring. Because corporate managers have better information about their future prospects and loathe cutting dividends, they often only pay high dividends if they are confident that their future earnings are robust enough to sustain the payout.
This explains why companies that pay high dividends today are routinely also the ones registering the fastest earnings growth tomorrow. Academics call this phenomenon the “dividend-signalling effect”. For investors seeking to benefit from the Asian growth story, high-payout companies should certainly be considered for their portfolio.
In a region laden with corporate governance landmines, focusing on dividends has the added benefit of steering investors away from potential blow-ups. By returning excess cash to shareholders, companies reduce the temptation to squander money on value-destructive investments, while also subjecting themselves to more stringent levels of stakeholder scrutiny when they next tap the markets for funds.
And because dividends can only be paid out of real earnings and real cash flows, focusing on dividends helps investors avoid companies with “fake” earnings. This is why Asian companies that pay good dividends are frequently also the ones with strong corporate governance standards.
Dividend stocks appeal to older investors
In addition, dividend stocks are increasingly popular with older investors. As a fund manager, it is interesting to observe how clients (especially older ones) tend to view dividends and share price appreciation in a different light.
The rational investor will argue that a dollar is a dollar, and whether that comes from dividends or capital appreciation should make no difference. Yet the reality appears to be quite different. While older clients have no problem spending from their dividend income, getting them to sell some shares to finance their consumption is often a lot more difficult.
Why is that so? My conclusion is that it all comes down to mental accounting. According to the Behavioural Life-Cycle Theory (proposed by economists Hersh M. Shefrin and Richard H. Thaler), an individual mentally breaks down their wealth into three separate, non-interchangeable components: current income, current assets and future income.
The temptation to spend is always greatest for current income and least for future income. Because dividends are viewed as current income, people are often happy to spend them. Capital gains, on the other hand, are viewed as future income, and the propensity to spend out of them is much lower.
In this scenario, as the individual grows older and retires, their perception of the difference between dividends and capital gains should mean that they prefer to fund spending out of received dividends. This should therefore see them investing more in stocks paying high dividends versus stocks paying low dividends, thus driving stronger outperformance of high dividend-yielding strategies.
In a world of ageing populations, the outperformance of dividend-yielding stocks will be underpinned by the demand from the growing cohorts of retirees and people who are soon to retire. This makes them attractive investments on a longer-term basis.
High dividend yield stocks are no longer expensive
Despite the structural benefits of investing for dividends in Asia, investors have largely shied away from these stocks over the past few years. Part of their distaste stems from the relatively high cost of these high dividend-yielders. Compare the price-to-earnings (P/E) discount of around 3.5 ratio-points that these names were offering in March 2019, when quantitative easing was introduced, to the mere 1.2 P/E ratio-points gap in the middle of 2013, and it is easy to see why investors were put off.
Today, much of that has changed. High dividend-yielding stocks are now sporting P/E ratios that are almost five ratio-points lower than the market median, a gap that is more than one standard deviation away from the historical average. This represents a rare opportunity .
Another reason for investors’ past reticence towards Asian dividend stocks had been their expectations for rising interest rates. However, these have now been reversed, with most anticipating rate cuts over the next two years.
With the four medium-term headwinds of ageing demographics, technological disruptions, income disparity and still-elevated debt levels continuing to loom over global economies, structural deflation is here to stay. This also means that rates are set to stay lower for longer and that investors will need to start looking for income alternatives again.
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On that front, Asian dividend stocks stack up pretty well. After all, the region boasts of one of the highest dividend yields globally and is only bested by Europe. However, compared to their Western counterparts, Asian companies have much better prospects for growing their future dividend streams, supported by steadily rising profitability and all-time low gearing.
Multitude of dividend surprises to come
The brimming free cash flow on corporate balance sheets is increasingly putting pressure on Asian managers to boost the proportion of profits paid out as dividends, which remains lower than many other global regions.
If Asian companies do start to hike their payout ratios and dividends, it can be an exhilarating experience for shareholders. Our research has shown that such companies (we call them Dividend Surprises) often undergo a valuation re-rating on the back of the associated improved capital management and enhanced corporate governance, and this can potentially lead to share price outperformance.
Unfortunately, these opportunities are usually rare and hard to find. However, that is now starting to change. The mounting pressure on management to distribute the swelling cash in their bank accounts is coinciding with a string of regulatory changes that are designed to bolster the trend of increased payout ratios.
The effects have started to take shape over the last couple of years and are already evident in companies such as Korean conglomerate Samsung Electronics. The company is already preparing its third three-year Shareholder Return Program, an initiative that began in 2015. In a market where chaebols (industrial conglomerates controlled by one owner or family) have traditionally scoffed at dividends and minority shareholder interests, what Samsung Electronics is doing is noteworthy, and will encourage others to follow suit.
With a stream of Dividend Surprises set to spring up in the region over the next few years, long-term investors would do well to pay heed.
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