Investing in Asia for Dividend Income
Charles Rotblut will speak at the 2015 AAII Investor Conference this fall; go to www.aaii.com/conference for more details.
Charles Rotblut (CR): In your Asian funds, what guides your allocation decisions?
Jesper Madsen (JS): For the Asia Dividend Fund, it is really a matter of saying, “What is the bottom-up telling us, in terms of the availability within the universe?”
Maybe I can take a step back and lay out the broad universe for you, because it also helps explain how we construct a portfolio. In Asia, the dividend yield for the Asia Pacific region is sitting around 3%. That’s inclusive of Japan and using the MSCI All Country Asia Pacific Index as a proxy for the general market. If you turn around and look at the U.S., there you would see a dividend yield of about 2%. These are the 2011 consensus estimates for both those numbers.
I think this is probably contrary to what most people think of and expect when they think about Asia, because they tend to think entirely about growth. Dividends often will just be a passing thought, not even part of the equation. But when you look at the long-term returns out of Asia, just like anywhere else, dividends do end up accounting for a substantial part of the total return, if not most of the total return, depending on what periods you’re looking at. So Asia is no different, from that perspective.
Where it gets more interesting, though, is that you get not only a yield pickup, but also faster dividend growth. We froze the index numbers of both the S&P 500 and the MSCI All Country Asia Pacific Index between 2002 and 2009. What we found was that, over time, the Asia Pacific constituents grew their dividends, annualized, around 16%, compared to 6% for the S&P 500. Not only did you enjoy a higher dividend yield throughout this period, you would also have enjoyed a higher growth rate in the underlying dividend. Now, some of that has come from currency exchange rates, but most of it is just raw growth in earnings that have been feeding into dividend growth.
What’s even more interesting is that, when you’re a portfolio manager looking for total return, you care about the yield, you care about the growth in that underlying dividend, but you also care about issues such as “How broad is my universe that I can work with?” and “Is it broad enough to put together what I would call a wholesome, or a complete, diversified portfolio?” And here you find that, both for the constituents of the MSCI Asia Pacific Index and the S&P 500, those indexes pay out, roughly, around $200 billion in dividends. When you turn to Asia, you have more than a dozen different currencies, different countries, different monetary and fiscal systems, and even developed and emerging markets.
So, for instance, when I buy a telecommunications provider in a place like Taiwan or South Korea, that is a very different telco than you would find if you looked to India or Indonesia. Again, the yields would be different, the growth rates would be different, the need for capital investments would be different.
We have a very rigid yardstick for the way we measure every company that we consider for the fund or that is a current holding of the fund. Our basic philosophy is that it has to score well on dividend yield today as well as on dividend growth over the next three years. Then it’s somewhat of a sliding scale trade-off between the two.
For instance, if we get a high dividend yield today, we can accept a lower future growth in that dividend, and vice versa. If you look at the portfolio construction, you’ll see an all-cap strategy. If I use rough numbers, about half the portfolio (it’s a little less now; it’s actually closer to 40% of the portfolio) is sitting in large caps, with the remainder being allocated to small- and mid-size companies. Those would be companies with less than $5 billion in market capitalization.
The rationale is quite simple: With the large-capitalization companies we try to achieve stability in dividends. So these will be telcos, utilities, consumer staples—the kinds of companies that you have a high degree of certainty will pay out a dividend, even during tough times. By anchoring the portfolio in these 4%–6% dividend yielders that might be growing in the high single digits to low teens, we can invest to a greater extent in small- and mid-size companies where you take on more risk, both in terms of the business model and the underlying dividend stream. That said, the reason why we’re there is, obviously, for the growth that should be offsetting some of the risk that we’re taking on. Because we’ve already achieved some stability by anchoring the portfolio, we can afford to take on that risk in the small- to mid-sized segment.
CR: In terms of the country allocations, then, are you just mostly looking for good stocks, or are you actually trying to target a certain country?
JS: We’re not trying to target any country. Again, we do have a benchmark, the MSCI All Country Asia Pacific Index, but to be perfectly frank, there is no index capturing dividend investing in Asia, simply because not that many people pursue this kind of strategy, even today. So we don’t have a specific target that we go for when we allocate to the countries.
But let’s take Japan as an example. There, the benchmark has about 37.5% allocated to Japan. We have 21% allocated to Japan. Again, we feel that there’s a very strong case for having Japan as part of the portfolio, in terms of dividend yield and dividend growth, and also in terms of diversifying the risk profile of the overall portfolio. But we don’t feel, from a bottom-up perspective, that we can honestly say that we can allocate all the way up to 37% or even 40% into Japan for this kind of strategy. That’s why we would be significantly underweighted; right now we’re about 16% underweight in Japan, for instance.
If you go further down the list, you’ll see that we underweight India. And the rationale there is as follows: In India, we find good growth optionality, a lot of good growth companies, but the problem is that India has been starved of capital for so many years that they have a need for reinvestment. The returns on the marginal investment are still so high that it actually makes sense for Indian companies to plow earnings back into the businesses. As a result, they don’t pay out much. That, combined with high multiples, means India is one of the lowest-yielding markets in Asia. That just makes it tough for us today, with the current market situation, to find candidates that would be both growing enough and yielding enough.
If you flip it around, you’ll see that we have a very significant overweight to a country like Thailand. Thailand makes a lot fewer headlines, and if you look back a little bit more than a year, all the headlines would have been quite negative because of the rioting that took place. It’s a country that is facing some real macro-political issues that are still ongoing. They just had an election that went quite smoothly, all things considered. I just came back from Bangkok, and it sounded like people in general are currently looking at the situation from a quite benign view. They think that there will be some relative stability at least for 12 months. So the point is that because Thailand was grabbing negative headlines at the outset of 2010, we would find quite high dividend yields and still quite attractive growth rates. As a side note, Thailand was one of the best-performing markets in Asia back in 2010, in spite of all the negative news flow.
It just goes to show that sometimes being a bit of a contrarian investor in Asia, maybe looking in areas of the market that are less positively viewed by international investors, can work out in your favor. Once investors have a positive view and there are positive headlines, often you’ll also have to pay up for the company. The strategy of the Asia Dividend fund tends to be very valuation-conscious. As a result, we have to be somewhat contrarian and look at the parts of the market that are a little bit beaten up relative to some of the other areas of the marketplace.
CR: Regarding Japan, have you done anything different with your analysis since the earthquake? Have you made any adjustments?
JS: It did not change my view on Japan fundamentally, because we were not invested with the companies that were at the front lines of this—nuclear-related names, utility-related names, the banks. Because we were not invested with those companies and because, for the most part, talking to the management teams of our holdings, we could not see a structural shift or decline in the businesses, we’ve stuck with our holdings in Japan. Granted, there would be some write-offs related to the earthquake, but that’s more transitory, it’s not something that was permanently impairing the business.
But I have to say, when Japan is the part of the portfolio that you expect to have some stability compared to some of the other emerging parts of Asia, it is frustrating having about 20% of your portfolio sold down by 15% in short order. Again, because of our all-cap approach, we hold a lot of small- and mid-size companies in Japan, companies that are not household names. Those were some of the ones that were sold down the hardest, because people were just looking for liquidity. They also snapped back very quickly. We chose to basically sit back and watch, because we knew that piling in to a trade that was crowded like that would not make a lot of sense, especially since the businesses were not impaired in the long term.
CR: Does an investor looking at Asian companies need to change his analysis from what he looks for in a U.S. company?
JS: I think, as of late, people have come to realize that you have to be careful about which company you invest in. Especially with some of these reverse mergers of smaller Chinese companies, it’s very hard for U.S.-based investors who do not travel to the region to verify that these are actually true businesses—how much of this is just made up, and how much is actually tangible in terms of products or a footprint on the ground. [A reverse merger is when a private company acquires a public company, allowing the private company to go public and bypass the lengthy process of an initial public offering.]
In terms of looking at the financial statements, people just have to use their own common sense. We analyze on a cash flow basis, so that’s a little bit cleaner, it’s a little less managed or manufactured, compared to the income statement. That helps a great deal. We line up companies mainly in the cash flow and balance sheet sense, which helps clean out some of the noise that you get in the income statement. We care more about the ability of a company to drive growth in dividends than the variations in quarterly reported earnings.
And I can tell you that you become a very different investor once you focus on that annual growth in the dividend. Because that means that stock prices become less meaningful, the quarterly or even semiannual earnings become less meaningful, and you can take a longer-term view that most people in the marketplace cannot afford. It’s too much of a career risk, to be honest, for most people out there.
If you think about it in a different way, you have between 3%–4% of your long-term total return in hand via the dividend, which is a low-volatility component of total return. When you enter the calendar year, you already know, with a high degree of certainty, that if you hold until the end of the year, this is the kind of return that these companies, at least via the dividend, should be paying you. That allows you to be a lot less aggressive about going for earnings growth. You can now be quite happy, perhaps, investing with companies that would grow their dividends in the high single digits to low teens, because when you add that up in terms of “What is my total return?” you actually still get a very competitive total return.
You have yield, and then you have growth in the underlying dividends, and it’s the growth of underlying dividends that will facilitate capital appreciation over longer periods. It does mean that you have to come at these markets with a long-term view, because there will be volatility in terms of how much your assets are worth on any given day. But, if you can just focus on the long term, which is the stream of dividends you are paid today and how that stream will grow over time, I think that will make you a better investor when it comes to volatile markets like Asia’s.
CR: Just to clarify, you are making sure not only that the dividends are increasing but also that the cash flow itself is consistently positive?
JS: Yes, we model out our companies to gauge the free cash flow and how quickly the dividend should grow over the next three years. We assess what is left over for shareholders after a company is done investing in its business (we want to see ongoing capital investment) and paying off debt, along with how much of that is paid out. So that’s why we focus more on the cash flow statement, because that will give you the true capacity or ability of a company to pay a dividend.
Now, the reason why we meet with management face to face, after we’ve already analyzed their ability to pay out a dividend, is to ask the question: “What is your willingness to pay the dividend?” That sometimes is a bit tougher to gauge, or more frustrating. Sometimes companies will generate plenty of cash flow, but they are unwilling to let go of it. So for the companies that we invest in, we have to have both the ability and also the willingness by management to pay out that dividend.
CR: You wrote on your site about the dividends really being a form of corporate governance. Could you elaborate on that?
JS: I think this is not just for Asia, this is quite universal—but in Asia, we have very concentrated shareholding structures, especially relative to the U.S. So often 50%, 60%, and sometimes even more than that, of a company will be held by a majority shareholder, whether it’s the founding family, a conglomerate, or the government. And these are the same people who hired management. It doesn’t take much imagination to think of scenarios whereby you can have a good growth company but see most of the cash flow siphoned off into other avenues that will basically go around minority shareholders. So having a very solid dividend, where maybe the bulk of or half of earnings will be paid out in dividends, shows you a recognition by the majority shareholder and the company management that they need to pay the owners of the business in line with their ownership. And that includes minority shareholders.
It’s a soft issue, it’s intangible, but I still believe that it leads to tangible results over the years—especially if you avoid being invested with companies that are fraudulent. It also gives you a sense of whether or not money has been made. Going back to the question: How do you analyze the financial statements of these companies? Well, you can at least take some comfort from the fact that if they say they make $100, and they pay you $60, you know first and foremost that there’s less money that can be siphoned off to other places. There’s less money piling up in the bank account that may or may not be real. Because you have now been paid, in hand, in hard dollars.
You might also have some intangible signals sent to you about the financial reporting and the stability around that. Dividend-paying companies, all things being equal, on average, have, in my mind, better financial reporting. And because you have an acknowledgment by the majority shareholder that minorities need to be paid in line with their ownership, you also have a better corporate governance structure. If you look at the reverse-merger firms that have gotten themselves in trouble in the U.S., about 20 or so of them, none of those paid a dividend.
However, I want to stress that that doesn’t mean you can just look at dividend-paying companies and think, “I do not have to worry about corporate governance issues.” That is not at all what I am advocating here. I’m just saying that on average, it seems that dividend-paying companies are less prone, for various reasons, to being caught up in financial and corporate governance issues. On a one-to-one basis, you still need to do your homework.
Last 3 Yrs
Last 5 Yrs
|Matthews Asia Dividend Inv (MAPIX)||-1.6||22.8||13.2||na||3.6||1.14|
|Matthews China Dividend Inv (MCDFX)||-5.4||22.5||na||na||2.4||1.50|
|MSCI Pacific Index||-7.1||16.1||0.2||-0.7||—||—|
|na=not available. MAPIX inception date is 10/31/2006, MCDFX inception date is 11/30/2009.|
|Source: Morningstar Inc. Data as of August 31, 2011.|
CR: In terms of foreign exchange rates, is there any concern for investors? How much should investors factor in fluctuating exchange rates when they are looking at some of these stocks and the dividend payments?
JS: The way that we look at currency is, first and foremost, from a bottom-up perspective. We try to understand: How will different currency movements impact the revenues of the firms in the portfolio? If in the next quarter you have an appreciation in your currency, that could be a problem in terms of accounting for overseas revenues.
Now, I would stress that, with Matthews in general, we have always tended to steer our investments toward the companies that cater to the domestic economies. The long-term trend that we see is a rise in household wealth resulting in changing spending patterns for individuals in Asia as they become richer, and as they see their earnings grow year in and year out, and as they see their asset base grow as well. So you will find very little exposure, in general, to the exporters. Also you will find very little exposure to some of the materials and energy firms, because they’re very cyclical and, as a bottom-up investor, it’s very tough for us to see how management teams can add an edge above and beyond what is being set by global pricing. But that’s a general Matthews way of investing, not just the strategy for the Asia Dividend fund.
In terms of how to view currency from a personal perspective, investors have to make a call on whether or not they want to diversify out of the dollar. And that’s a call that I will leave up to them. If the dollar depreciates from here on compared to the rest of the world or a basket of Asian currencies, then you stand to benefit, because the value of the basket of dividends that you would be receiving would be increasing in U.S. dollar terms. But should there be a strong rally in the U.S. dollar, that could mean a pullback both in equities and in the value of the dividend stream once you tie that back to the U.S. dollar, even if you have underlying growth in the dividend in Asia.
CR: What about foreign taxes on those dividends? Obviously, if someone owns the stock in a taxable account they can qualify for foreign tax credit, but if they hold the stock in an IRA, they can’t get the credit back from those taxes. Are the taxes high, or are they pretty low, in Asia?
JS: It really varies from country to country: Some will have none; some will have upward of 20% or so withholding tax. Another issue is also qualified dividend income. There, again, it varies, depending on whether or not each individual country has a tax treaty with the U.S. Income, if it comes from non-treaty countries, would be considered non-qualified. We try to get around that to a certain extent, sometimes by buying ADRs (American depositary receipts), where you can still qualify for QDI status.
CR: Regarding China, I know there’s a lot of discussion about the banks and whether or not there’s a housing bubble. What’s your take on it? What are you seeing, in terms of where the economy’s headed?
With both of the dividend funds, we do not invest in any of the Chinese financial companies. It’s because of the lack of transparency in terms of the buildup of debt and the buildup of non-performing loans on the back of the stimulus lending that happened around 2009. That just means that we don’t have transparency in terms of the growth of the underlying dividend, because these banks have been very busy raising capital at the same time as they’re paying dividends. As we discussed, that just raises a flag for me.
In terms of the property developers, when it comes to real estate, we don’t hold any of the real estate companies in China. Instead, we have gone to Hong Kong and we have gone to Singapore to find companies that hold Chinese assets. For instance, there’s a REIT [real estate invesetment trust] in Singapore that holds a portfolio of mid-end malls in China. There you would achieve dividend yields of 6%–7%, depending on when you looked at the stock. But you would still get exposure to consumption and hard assets in China, for instance.
Up until very recently, buying consumer names in China was quite expensive in terms of the multiples you had to pay, and as a result you would achieve lower dividend yields as well. You have to, sometimes, use your imagination a little bit more in terms of finding proxies, because the most obvious proxies often will turn to out be higher priced in places like China, for instance.
CR: Are you noticing any difference in terms of dividend or payout policies for some of these Asian countries, in comparison with the U.S.? Are policies country-specific, or are they more dependent on the company?
JS: One example of a country-specific issue is what took place in Japan and led us to add Japan to our portfolio. Back in 2005 or thereabouts, Japanese companies went from having fixed dividend payments (no matter how well or poorly the business was doing) to a policy of paying out a dividend in relation to earnings.
Around 2005, we started seeing more and more companies come out in their three-year plans (companies there like to put out three-year forward plans) talking about dividend policies and about tying dividends to earnings for the first time. So that meant that we experienced dividend growth, in excess of already strong earnings growth, during this period as the portion of earnings paid out as dividends expanded.
Otherwise, in general, I would say, you would find, outside of Japan and South Korea, for the most part, cash is returned to shareholders via dividends. It’s still very much plain vanilla, whereas in the U.S., going into the financial crisis, more cash was definitely returned to shareholders via share buybacks than via dividends. For the most part, for people who are looking for income, Asia is still somewhat, I would say, innocent, in the sense that most cash is returned to shareholders via dividends, as it used to be in the U.S., before management stock options and whatnot took over.
CR: Is there a certain level of payout ratio, and I know it varies by industry, that raises a red flag that maybe it’s too high?
JS: Well, that goes back to why we look at the cash flow statement. We will say, “Okay, we can see that you’re spending X billions or hundreds of millions of dollars. You are only generating this much cash flow, you’re planning on paying a dividend of X, which means that now you actually have negative free cash flow that will have to be funded by debt or equity raising.” This is what you have seen with the banks in China, for instance. They’ve been paying you out of one hand and raising capital with the other, which raises some flags for that sector more broadly.
But this is why we look at the cash flow statement. We engage management, and we ask them, is this something that is structural? Is this just transitory? Because sometimes you will have one year where a company needs to make a pretty hefty capital outlay, and if it’s just a one-year investment, and if they say, “Okay, we will fund the dividend via debt for that one year, because we feel very comfortable about the long-term trend of cash flow,” we are okay with that. But again, there has to be a rational explanation, so it’s not year after year of dividends being funded out of debt or out of equity raisings.
Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.