Morningstar Advisor - October/November 2011 - (Page 42)

Spotlight The Case for Dividends in Emerging Markets By Samuel Lee If you believe in the developing world’s growth story, dividendpaying stocks might be the best way to capitalize on it. The emerging-markets story is all about growth, the red-hot kind. Paradoxically, the best way to benefit from economic growth may be to hold boring, dividend-paying stocks. Compared with the rich world, emerging markets have weaker rule of law, feeble protection for minority shareholders, and poorer management—all factors that have fed into relatively poor stock market returns for fast-growing economies in the past. Holding dividend-payers is one of the few ways individual investors can mitigate these issues. None of this matters, of course, if the market has already priced in the benefits of dividends. Fortunately, the “dividend bonus” may be undervalued thanks to the relative dearth of smart money in emerging markets and the difficulty of arbitrage. Before we delve into the case for dividends in emerging markets, it’s worth visiting why dividends are good in general. King Dividend Sweden’s yawn-worthy 1.77% dividend growth rate was the highest. With dividends accounting for the lion’s share of past market returns worldwide, it’s no surprise then that Dimson, Marsh, and Staunton found that dividend-payers have outperformed nonpayers in almost every country studied, both on risk-adjusted and absolute measures. To rub salt in the wound of efficient-markets models, the high-yield stocks had a lower beta, or sensitivity to the market’s performance, than nonyielding stocks. Risk-based theories have to add ugly epicycles to explain away these findings. The simplest explanation is best: Investors and managers have tended to overprice growth. Is It Different This Time? Ritter found that, for the period of 1900 to 2002, real per capita GDP growth and real stock market returns for 16 countries had a negative 0.37 correlation (“Economic Growth and Equity Returns,” Pacific-Basin Finance Journal, August 2005). In other words, if you traveled back in time to 1900 and invested in the stock markets of the countries you knew were going to be the fastest growing over the next century, you would have underperformed a strategy that did the exact opposite. It seems unintuitive that a bigger earnings pie doesn’t trickle down to current shareholders. Why has this been the case? GDP and total earnings growth tend to track each other, in principle allowing earnings per share to grow as fast as GDP—assuming no new share issuances, no new enterprises. In reality, a growing economy sucks in capital from domestic savers and foreign investors. Factories are bought, old firms fail, and creative destruction takes its toll. Old shareholders are diluted away, which is why no stock market grew dividends by more than 2% annualized over the 20th century. Rob Arnott and William Bernstein calculated that this dilution drag has led earnings-per-share growth to lag GDP growth in the United States by about 2 percentage points (“Earnings Growth: The Two Percent Dilution,” Financial Analysts Journal, September/October 2003). A later study found that dilution drag in London Business School professors Elroy Dimson, Paul Marsh, and Mike Staunton have assembled one of the most comprehensive databases of stock market returns, covering 1900 to the present. They’ve found that dividends accounted for the majority of stock market returns in every country they looked at. Of the 19 major countries in their database, Focusing on dividends seems stodgy and quaint when emerging-markets economies have been growing at a breakneck pace, with corporate profits coming along for the ride. Sure, emerging markets have experienced booms before, only to have major busts. But many argue that this time is different, that emerging markets will experience decades of high growth. Even if we accept this argument, we can’t assume they will offer higher equity returns. The link between stock market returns and GDP growth has historically been weak. University of Florida professor Jay 42 Morningstar Advisor October/November 2011

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2011

Morningstar Advisor - October/November 2011
Contents
Contributors
Letter From the Editor
The Emotional Burden
Where Are You Going for Yield?
Ahead of the Curve
How to Use a ‘Collar’
Why Dividends
Is Bond Investing All Uphill From Here?
Four Picks for the Present
Investment Briefs
The Risks of Stretching for Yield
For Banks, Uncertainty Reigns
The Virtues of Dividends
How Well Do You Know Templeton Global Bond?
The Case for Dividends in Emerging Markets
Finding Refuge in Value
Swift, Smooth, and Silent
Crack Open Closed- End Funds to Avoid the Relevance Paradox
Getting Beyond Labels in the ‘To vs. Through’ Debate
Handling the Headwinds
Bonds, Short-Term Bonds
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
A Prisoner of Pricing

Morningstar Advisor - October/November 2011