A strong link between payout ratios and corporate governance standards in emerging markets means focusing on companies with a decent dividend record is a good starting point if you want to avoid one of the major pitfalls of investing in this area.
This is according to Omar Negyal, manager of the JPMorgan Global Emerging Markets Income Investment Trust.
Negyal aims to deliver a yield on the trust that is 30 per cent higher than that of the wider market.
However, he is not just looking for a high headline yield, but a dividend that is sustainable with some potential for growth.
“What we really don't want to do is invest in the very high-yielding stocks only, because that's clearly going to lead to the risk of investing in yield traps,” he said.
“Instead, what we want to think about is a balance of risks in the portfolio; we want to think about the sustainability of the dividends of every company we invest in.”
Negyal said his strategy, which he referred to as “value plus quality”, allows him to deliver capital growth as well as income and represents “an attractive way of navigating this asset class” for every type of investor, not just those seeking a yield.
The manager splits the portfolio into three: 20 per cent is in stocks that have a yield of less than 3 per cent, but a superior dividend growth opportunity; 20 per cent is in stocks that simply have a high yield, of more than 6 per cent; and the majority is in stocks that yield between 3 and 6 per cent and offer the potential for long-term growth through re-investing dividends.
Portfolio breakdown
This approach has allowed JPMorgan Global Emerging Markets Income to maintain a decent yield, even after the coronavirus-related disruption. This figure currently stands at 3.48 per cent, well above the 2 per cent from the wider market.
Yet Negyal is positive for emerging market income as a whole, noting that despite last year’s economic upheaval, most companies in the sector continued to pay dividends.
“They've passed an important test,” he said. “On average, emerging market companies have paid around about 35 per cent of earnings as dividends over the years. Of course, management teams had to make difficult decisions and balance all sorts of risks, and in some cases, there were some big headwinds.
“But the overall summary is companies stuck to their payout ratios and that's a very nice starting point for us.
“I do always emphasise the payout ratio, because I think it's an important thing to highlight in emerging markets. It is a payout ratio-driven asset class and so earnings cycles are important.”
As well as dividing stocks into three groups according to dividend yield, Negyal also divides them into four groups based on the sustainability of their dividend. At the lowest-risk end are companies that maintain absolute dividends per share and have a progressive dividend policy; then those whose dividends change with earnings, which are relatively stable; then those whose dividends change with earnings, but are subject to short-term earnings risk; and finally those facing a potential temporary change in dividend policy.
Obviously the most desirable stocks are those in the first category, but the fact that these account for just 21 per cent of the portfolio reflects the difficulties faced by income investors in emerging markets.
Negyal has 22 per cent in stocks with dividends that are subject to short-term earnings risks, but he pointed out there are opportunities here as well. For example, he noted that banks were in “the eye of the storm” last year, due to their economic sensitivity and pressure from regulators to curtail dividends, but said their future looks much brighter.
Source: JP Morgan
“We can be selective within emerging markets and we can find the right opportunities within the banking sector,” he continued.
“The numbers around the capital ratios of banking systems look healthy to us in general, and also the numbers around how banks have covered the prospects for potential bad loans look pretty supportive.
“It might look like a pretty difficult sector on the face of it, but the numbers look very supportive in terms of the fundamentals.
“Then finally, it seems to us that those regulatory concerns and dividend curtailments are beginning to wane.
“That essentially means we can think about parts of the market which would have looked pretty challenging last year, we're actually rotating more into those areas to look forward to dividend-recovery opportunities.”
Data from FE Analytics shows JPMorgan Global Emerging Markets Income has made 127.32 per cent since launch in June 2010, compared with gains of 92.52 per cent from the MSCI Emerging Markets index and 71.18 per cent from the IT Global Emerging Markets sector.
Performance of trust vs sector and index over 10yrs
The trust is on a discount of 4.58 per cent, compared with 7.27 and 5.49 per cent from its one- and three-year averages.
It has ongoing charges of 1.16 per cent.