Dividends may help insulate in falling markets

When stock prices are falling, the cushion provided by dividends is important to risk-averse investors and usually results in lower volatility. During the 2008 financial crisis, the MSCI AC Asia Pacific ex Japan index fell 45% while the high dividend counterpart declined 37%. But as soon as sentiment recovered, the high dividend index also participated in the rally and rose higher. See Fig 1. Asia Pacific is the highest dividend payout region and dividend reinvestment has generated long-term outperformance.

Fig 1. Asia’s high dividend index fell less during the 2008 crisis and rose higher on recovery¹

A dividend focus helps to build a buffer in portfolios, the rationale being that investors still get paid an income stream while waiting for markets to recover and at current levels, Asia Pacific ex Japan’s dividend yields are attractive for most sectors. See Fig 2. But not all sectors offer good value, and expertise is required to select the good dividend payers with the most sustainably supported yields.

Fig 2: Asia Pac ex Japan’s dividend yields are attractive²

The question remains whether Asian corporates will continue to offer good dividends in downturns like the recent COVID-19 related sell-offs.

Sharp falls in earnings will likely put pressure on Asian corporate ability to pay dividends. However, many Asian listed companies have low levels of gearing and good EBITDA (earnings before interest, tax and depreciation) interest coverage with sufficient cash on the balance sheet to cover short-term liabilities. This is key in a challenging environment.

Dividend cuts have typically been less severe than earnings cuts. During the Asian financial crisis, dividends were cut but not to the extent of the fall in earnings. Back then, the payout ratios shot up as companies strove to maintain dividends. Conversely, when earnings took off after May 2003, dividends did not track a similar trajectory. See Fig 3. The bottom line: dividend paying stocks generally provide more stability, but one must be mindful of the downside risks; dividends could be cut further as companies shore up cash for operations.

Fig 3 : Dividends are less volatile than earnings³

Sometimes, a high dividend yield indicates a value trap – as the dividend yield may be high as a result of the share price being particularly depressed. With low interest rates and high volatility, yield-seeking investors will rightly look at high-yielding equities. However, chasing yield for yield’s sake or simple yield screening could lead investors into a classic yield trap whereby the highest yielding stocks have weaker quality characteristics – the last thing one wants in today’s environment. A deeper dive into the earnings and balance sheet strength of Asian corporates is imperative now in the face of earnings downgrades.

So how can one tell if companies can sustain their dividends in a prolonged downturn?

There are a number of metrics an investor can utilise to determine dividend sustainability. First and foremost is to see if the company enjoys sustainable earnings growth, i.e. receives steady revenue from ongoing operations. For this, utility and telecommunications companies are often cited as good examples, and this is the case in Asia, too.

Second, strong and stable balance sheet strength is crucial. Investors should question whether the company’s short-term assets can pay off its short-term liabilities; or does the company carry excess debt compared to its equity? A dividend paying company generally has high cash and low debt levels and/or low capex levels.

The third point follows from this: a company generally has to enjoy a strong free cashflow that can cover dividends. This means the company can generate regular sales that put cash in the bank and is not reliant on other balance sheet assets such as ‘intangibles’ on a strong brand, or long payment deferrals that could cause large fluctuations on the cash line. Also, companies that have the flexibility to defer capex should help support dividends.

Fourth, examine the company’s dividend history and if it has a record of cutting dividends. Investors should be extremely diligent in their investigations into why a company was forced to make those cuts. It is only in extreme situations that a company will cut its dividend, as it sends a signal to the market that the company is in a weaker financial position. One can draw conclusions by looking at the company’s actions during past sell-offs and downturns.

Eastspring’s Asian Equity Income team takes a long-term view on our stock positions and view the current disruption as a buying opportunity. We continue to believe that the businesses we own are durable and will outperform over the cycle. We purchase each stock with a margin of safety and are careful not to overpay, modelling each stock with a bull, bear and base case scenario.

We believe that owning companies that pay stable and growing dividends is a proven method for delivering attractive returns. Inevitably, certain types of stocks lend themselves to being good dividend payers. Utility or Telecom stocks have steady cash income, are mature companies with an often-long track record of dividend payments, and predictable (within reason) capex.

Banks and insurance companies, too, tend to have fairly steady income streams which make dividend payments steady, if not always spectacular, while property stocks also have consistent revenue income from tenants. And perhaps surprisingly relative to popular perception, there are many opportunities in cyclical areas like Technology and Industrials for investors to gather high dividend yields.

When yields are low and going lower – bonds become expensive – so investors sometimes buy into defensive equities as “proxies” for owning bonds because they are perceived to be stable. This is mostly evident in Consumer Staples, Healthcare, and Utilities. We are underweight these areas on valuation grounds but are cognisant that these businesses tend to be less cyclical and maintain exposure in the portfolio for diversification purposes.

Amidst the sell-offs, we are taking advantage of better price entry points to rotate the portfolio into high quality dividend payers with strong and defensible balance sheets. Energy, Financials, and Communication Services sectors have high yields and valuation support, and we are overweight. We also have long-term conviction in some interesting names related to 5G, semiconductors, consumer and real estate, where we continue to look for upside by focusing on favourable fundamentals.

As the markets gyrate from day to day, we aim to deliver stable performance amid market uncertainties from our dividend payers.