INVESTMENTINSIGHTS

The case for income in emerging markets

IntroductionThe words ‘emerging markets’ and ‘dividend play’ have not commonly been associated in the past, but the simple fact is that the combination of income and growth has been a powerful source of total returns in emerging markets. Today, emerging markets are an increasingly sustainable and stable source of income because corporates are able and willing to pay dividends. This is true across a diverse range of sectors and countries.

In this paper, Richard Titherington, Chief Investment Officer for emerging markets equities and portfolio manager of the JPM Emerging Markets Income Strategy discusses the case for income in emerging markets and the diversification benefits that emerging market income offers to UK income investors. He explains why identifying sustainable dividends has long been a pillar of the emerging markets team’s investment process. Finally, he considers whether this is a good entry point for emerging markets.

Income and growth: A powerful source of total return

The power of equity income strategies is well documented in developed markets, but the same is true in emerging markets. Today, emerging market income funds represent less than 1.5% of the total EM universe, compared to approximately 10% in the UK and US (Source: EPFR, as at end July 2012), which suggests there is ample room for income investing to become a much greater component of investors’ emerging market portfolios.

In our view, there are two key questions that need to be answered. Is there a case for income in emerging markets? And, if so, is this a good entry point, both for emerging markets and for income-paying stocks within emerging markets? We will attempt to answer these two questions in turn in this paper.

Richard Titherington, Chief Investment Officer

FOR PROFESSIONAL CLIENTS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION

2

INVESTMENTINSIGHTS

An increasingly sustainable income source

In our view, the case for income in emerging markets centres on the fact that the asset class offers an increasingly sustainable and stable source of income. Equity investors don’t buy GDP growth, but corporate earnings and, specifically, the dividends companies pay out. Therefore, the most impressive reforms in the emerging market asset class over the past decade were arguably not the macro reforms we’re all familiar with, but the multi-year improvements in corporate capital discipline and governance, and the resulting improvement in operating efficiency and reduction in financial leverage. It is these fundamental improvements which underpin the sustainability and growth of income from emerging markets.

In the 1990s, emerging market equities were challenging for the bottom end of the league table in terms of return on equity (ROE) – the most basic measure of profitability. Emerging market corporates had too much debt on their balance sheets and prioritised market share gains over profitability. The Asian Crisis was arguably a watershed for the management teams of many emerging market companies, teaching important lessons about capital discipline. During the course of the next decade, emerging market corporates shifted their focus to their core businesses, moved from market share and volume objectives to profitability targets, and placed a greater reliance on internal cashflow to fund investment. A simple DuPont decomposition reveals that the result was a lowering of debt and rising returns. This led to a convergence towards developed markets levels of profitability and a move towards the top of the league table globally.

Exhibit 1 - Emerging market payout ratios stable as borrowing falls

Source: MSCI, IBES, Morgan Stanley as at June 2012, GEM universe. E = MS estimate. Past performance is not an indication of future performance. For illustrative purposes only

0%

10%

20%

30%

40%

50%

60%

0%

20%

40%

60%

80%

100%

120%

1987 1990 1993 1996 1999 2002 2005 2008 2011

Net Debt/ Equity (lhs) Payout Ratio (rhs)

3

INVESTMENTINSIGHTS

The dividend opportunity is therefore dramatically different today than it was ten years ago. But is this sustainable? Well, the good news is that recent years have brought a significant cyclical challenge to test the robustness of this profitability improvement and change in management attitudes, and emerging market corporates have passed with flying colours. Indeed, improvements to corporate discipline and dividend policies continue to come though in certain countries. The shift to a more investor-friendly dividend environment in Russia is one of the best examples today. While the reason for this overall new policy may be to increase the government’s income from state-controlled enterprises, there is no doubt a better set of dividend policies is a positive development for the equity market as a whole.

As a result, structurally higher ROE in emerging markets should continue to underpin earnings growth, the key driver of returns from emerging market equities. Exhibit 2 shows the long-term growth in dividends and earnings for the MSCI Emerging Markets Index. The fact that emerging markets have consistently delivered higher earnings per share (EPS) growth than the developed world is perhaps not a surprise. However, what is less well understood is that dividends per share growth has also been higher (17.5%), both relative to the developed world and to emerging market EPS growth. We believe these trends are sustainable as increased ROE allows profits to participate in the higher economic growth we expect from emerging markets. Ultimately, it is this which underpins our optimism for the long-term earnings and dividends trajectory for emerging markets.

Exhibit 2 - Robust profitability continues to drive earnings

MSCI Emerging Markets Index: long-term growth in dividends and earnings

Source: UBS, Data as at end May 2012

0

100

200

300

400

500

600

700

800

900

1000

Mar-19

90

Mar-19

92

Mar-19

94

Mar-19

96

Mar-19

98

Mar-20

00

Mar-20

02

Mar-20

04

Mar-20

06

Mar-20

08

Mar-20

10

Mar-20

12

EM EPS (Fwd) EM DPS DM EPS (Fwd) DM DPS

MSCI Emerging Markets Index: long-term growth in dividends and earnings

Index, 100 = March 1990

EM

DM

EPS DPS

Emerging Markets 12.1% 17.5%

Developed Markets 8.4% 7.4%

10 years CAGR

4

INVESTMENTINSIGHTS

Importantly for investors, dividends also tend to be more stable and robust than earnings. We now have over 20 years of data on earnings per share and dividends per share in emerging markets and the difference in the relative volatility is evident. It hasn’t all been sunshine and roses: in 1998/1999 and 2008/2009 dividends were clearly cut; however, they were cut to a far lesser extent than earnings, which halved. This comparative resilience means dividends can offer investors a cushion against volatility in earnings, and reinforces the attraction of having a dividend component to stock selection.

The power of compounding

As emerging market corporates increasingly take advantage of their ability to return capital to shareholders, we expect dividends to continue to grow significantly. Over the next five years, we expect emerging market dividend growth to average 12% per annum. The power of compounding means this superior growth has the potential to generate a significant long-term return premium.

Dividend compounding – the eighth wonder of the world

The benefits of compounding superior levels of growth are perhaps best illustrated by an example. Take two consumer companies – Tesco in the UK and Arcelik in Turkey. Both have a current yield of close to 4%. However, one has one year dividend growth of 27%, the other of 2.1%. Even if Arcelik sees its dividend growth moderate, the difference over a decade is significant.

Given the power of compounding, we believe that it is this difference in the rate of dividend growth that should be the key attraction for UK investors in pursuit of long-term total returns.

5

INVESTMENTINSIGHTS

The combination of income and growth has been powerful for emerging market dividend strategies over time. Not only have emerging markets strongly outperformed the UK, but higher yielding emerging market stocks have consistently beaten the wider emerging market asset class over the last fifteen years. Exhibit 3 shows the performance of the highest yielding third of stocks in the MSCI Emerging Markets Index, which have generated a total return (including dividends) of 15.8% per annum since the end of 1998, almost double the return of 8.8% per annum from the standard MSCI Emerging Markets Index (data to end June 2012).

Exhibit 3 - The combination of income and growth has been powerful

Emerging markets have strongly outperformed the UK...

Source: Bloomberg, FTSE, MSCI , UBS, rebased to USD, as at end June 2012. Annualised returns. High yield as provided by UBS. Calculated as top third yielding stocks in MSCI EM Index. Past performance is not an indication of future performance. For illustrative purposes only

…. and higher yielding EM stocks have beaten the EM index

Source: Factset as at 30 June 2012. Top third of stocks in MSCI EM Index by yield, region neutral.

Emerging markets have strongly outperformed the UK... Index, 100 = 31 December 1998

0

200

400

600

1998 2000 2002 2004 2006 2008 2010

MSCI EM High Yield

FTSE Index

MSCI EM

…. and higher yielding EM stocks have beaten the EM index

80

100

120

140

160

180

Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09

Top third of high yielding stocks

Index, 100 = 1 January 1997

6

INVESTMENTINSIGHTS

Attractive return profile across economic environments

We believe dividends are much more than a defensive place holder during periods of heightened market volatility. Rather, they are part of a long-term secular theme. The continued outperformance of high dividend yield strategies is one of the most defining trends in emerging markets.

In simple terms, there are five basic market environments – markets go up, markets go up a lot, markets are flat, markets go down and markets go down a lot. We would expect a well-managed income strategy, one which goes beyond simply maximising yield and also incorporates dividend growth, to outperform in four of those five market environments – the exception being rapidly rising markets. High dividend paying stocks with high dividend growth have outperformed lower yielding stocks over time. Simply by thinking with a dividend mentality, you are already fishing in a pool of stocks that has outperformed (with lower risk) over the long term.

Exhibit 4 - Attractive risk/return trade-off

Stocks with high dividend yield and high dividend growth tend to have a higher return and lower risk than the benchmark

Source: BofA Merrill Lynch GEM Quantitative Strategy ,MSCI, IBES, Worldscope

The pattern of relative performance of an investment approach which combines high dividend yield and high dividend growth is very telling. Unsurprisingly, this approach has outperformed significantly when emerging market equities have fallen (eg 2000-03 and 2007-08). However, perhaps more interestingly, this approach has held its own relative to other investment approaches even when markets are rising.

GEM Index

High Div Yield +High Div Growth

High Div Yield +LOW Div Growth

Low Div Yield +HIGH Div Growth

Low Div Yield +Low Div Growth

0%

5%

10%

15%

20%

25%

34% 36% 38% 40% 42% 44% 46% 48%

Stocks with high dividend yield and high dividend growth tend to have ahigher return and lower risk than the benchmark

Return = Annualised Performance

Risk = Probability of a 12m negative return

7

INVESTMENTINSIGHTS

Emerging market income funds may therefore offer investors greater downside protection than standard emerging market funds. One characteristic of emerging markets equities that we do not expect to change over the next decade is volatility. For new investors to the asset class, this volatility is often difficult to cope with. An income strategy offers a solution to this problem, providing investors with an incentive to invest for the long term, because they are being paid to wait.

However, perhaps less intuitively, income strategies also show good participation in gradually rising markets and have delivered consistent, strong returns across full market cycles (see exhibit 5). This supports our approach of constructing a balanced income portfolio that combines stocks with lower yields than our 4% target but significantly higher growth with stocks with higher dividend yields and high growth.

Exhibit 5 - Strong performance in diverse environments

Stocks with high dividend yields and high dividend growth perform well in rising and falling markets

Source: BofA Merrill Lynch GEM Quantitative Strategy ,MSCI, IBES, Worldscope

Diversifying and diversified

In income investing, sustainability is key. Consequently, investors require the broadest opportunity set possible to ensure diversification. Emerging market income serves as a diversifier to traditional UK income sources and, as a global asset class, offers healthy diversification across a range of countries, currencies, sectors and companies.

In the first half of 2012, 64% of all UK dividends came from just 15 companies and 36% came from just five companies (Capita Registrars UK Dividend Monitor, Issue 11). The suspension of BP’s dividend in 2010, which resulted in a drop of almost 10% in total UK dividends, illustrated how dangerous this concentration can be. Emerging market income allows investors to look beyond the concentrated UK equity income market and access a much broader range of high yielding stocks in a different asset class.

3.9%

-6.3%

-0.9%

-5.0%

14.4%

8.7%

-0.6%

-12.2%-15%

-10%

-5%

0%

5%

10%

15%

20%

High Div Yield +High Div Growth

High Div Yield +LOW Div Growth

Low Div Yield +HIGH Div Growth

Low Div Yield +Low Div Growth

Rising Market

Falling Markets

Annualised Median 1-Month Return

Stocks with high dividend yields and high dividend growth perform well inrising and falling markets

8

INVESTMENTINSIGHTS

New equity supply has contributed to a significant expansion of the emerging market investment universe in recent years, with the number of investable companies growing fourfold since 2003. This makes a diversified income strategy in emerging markets possible today in a way it wouldn’t have been ten years ago. Today there are 366 emerging market companies with a forward estimated yield of greater than 4%, a market capitalisation of at least USD 1 billion and average daily trading volumes of USD 5m or more. Only 59 stocks in the UK meet these criteria. In fact, there are more emerging market stocks with a prospective yield over 4% than there are FTSE All Share stocks yielding more than 2%. Lowering the yield to 2% produces a list of over 800 stocks in emerging markets and just 152 in the UK (Bloomberg as at August 2012) .

If the pillars of emerging markets income are compounding and diversification, then we believe there is little sense in investors confining themselves to only one emerging region. Historically, investors have used emerging Asia for income, but have overlooked compelling opportunities in Latin America, emerging Europe, the Middle East and Africa. From Brazilian utility companies yielding 9% to South African banks yielding 4.5%, there is a much broader opportunity set than just one emerging region.

Dividends are a valuable barometer of the health of a company

Dividends have long been at the heart of our fundamental, bottom-up investment process because of what they can tell us about the quality of a company. Our process is based on two questions: is this the kind of business we want to own, and at what price would we buy and sell it. To answer the first question, the portfolio managers work closely with the analysts to build a deep understanding of the business by considering the underlying economics, the duration of future growth and the strength of the company’s governance. If the business is deemed to be of sufficiently high quality based on these factors then the analyst’s forecast for the stock’s five-year expected return is used to answer the second question.

We use a simple and common valuation framework called ‘Rigor’ (see Exhibit 6) for forecasting five-year expected returns. This framework evaluates the fundamental expected return for a company through four sources of return: earnings growth, dividend, change in valuation and currency. Future profitability and the size of the reinvestment opportunity define earnings growth and dividends. The market ultimately determines the change in valuation and currency.

Exhibit 6: Rigor

For illustrative purposes only.

Earnings growth

Dividends

Earned bythe company

Delivered bythe market

Change invaluation

Currency

Expected return =

Rigour framework

9

INVESTMENTINSIGHTS

Dividends are at the centre of this research framework, because we believe they provide a useful barometer for understanding a company’s capital allocation and cashflow management. Put simply, we believe that without understanding how cash flows through a business, the business cannot be properly valued. Dividends reveal how companies are generating and deploying cash, which is why they are integral to our conversations with companies. If they are not paying it out, the first question we need to ask is ‘why not?’ Dividends provide a useful window on corporate governance and serve to align the interests of management with minority shareholders.

Focusing on dividends does not mean only looking at yield. A high dividend yield could be the product of a high payout ratio, where a large percentage of the profits is paid out to shareholders as dividends. While this may be sustainable in the short term, it reduces the funds available for reinvestment in the business and therefore undermines the company’s ability to generate strong profits in the future. As such, between two companies offering the same yield, we would choose the one with the lower payout ratio, all else being equal, because it improves the likelihood that the dividend will be sustainable.

Another problem with a high dividend yield strategy is that a stock’s yield might be high simply because its price has fallen significantly. Stocks with high dividend yields and high dividend growth tend to perform better than stocks with high dividend yield but low growth. As such, a high dividend yield alone is not enough to support an investment decision. Our investment process places an emphasis on quality, consistent dividend payers that emphasise growth as well as yield.

Is this a good entry point for emerging markets?

The second question we posed at the start of this paper was whether now is a good entry point for emerging markets. We focus on a crude but nonetheless useful measure to answer this question, looking at the price-to-book (P/B) ratio for the asset class. Historically, investors have been paid to own the asset class at a P/B of 1.5x or below, while it has been beneficial to be cautious when the P/B has been at 2.5x or higher.

Today, we believe emerging market equities are a value opportunity awaiting a catalyst. Developed market uncertainties are clearly creating an opportunity to enter emerging markets, with P/B valuations flirting with the 1.5x crisis level. Historically, this level has proved to be an attractive entry point for investors with anything more than a one-year investment horizon. The message is consistent if you look at price-to-earnings (P/E) ratios, including forward P/E measures as well as those based on trailing earnings. All suggest that emerging markets are trading at a discount to their historical average. Importantly for income investors, the relative P/E of high yield stocks in emerging markets is not significantly higher than lower yielding stocks, despite the current search for yield.

In terms of a catalyst, convincing measures in Europe to break the vicious cycle of bank fragility, fiscal solvency and growth would obviously help. We also need to see more proactive easing in China, particularly as global growth hits a soft patch. Emerging markets are becoming ever more polarised between the cheap BRIC markets (Brazil, Russia, India and China) and the more expensive, defensive, smaller markets such as Mexico, Indonesia, Chile and Malaysia. Even in India, which has traded at growth valuations for the last decade, equity valuations and the currency look increasingly attractive.

10

INVESTMENTINSIGHTS

FoR PRoFESSIonAl ClIEnTS only – noT FoR RETAIl USE oR DISTRIbUTIon.

This document has been produced for information purposes only and as such the views contained herein are not to be taken as an advice or recommendation to buy or sell any investment or interest thereto. Reliance upon information in this material is at the sole discretion of the reader. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. The results of such research are being made available as additional information and do not necessarily reflect the views of J.P.Morgan Asset Management. Any forecasts, figures, opinions, statements of financial market trends or investment techniques and strategies expressed are unless otherwise stated, J.P. Morgan Asset Management’s own at the date of this document. They are considered to be reliable at the time of writing, may not necessarily be all-inclusive and are not guaranteed as to accuracy. They may be subject to change without reference or notification to you. Both past performance and yield may not be a reliable guide to future performance and you should be aware that the value of securities and any income arising from them may fluctuate in accordance with market conditions. There is no guarantee that any forecast made will come to pass.

J.P. Morgan Asset Management is the brand name for the asset management business of JPMorgan Chase & Co and its affiliates worldwide. You should note that if you contact J.P. Morgan Asset Management by telephone those lines may be recorded and monitored for legal, security and training purposes. You should also take note that information and data from communications with you will be collected, stored and processed by J.P. Morgan Asset Management in accordance with the EMEA Privacy Policy which can be accessed through the following website http://www.jpmorgan.com/pages/privacy.

Issued in Continental Europe by JPMorgan Asset Management (Europe) Société à responsabilité limitée, European Bank & Business Centre, 6 route de Trèves, L-2633 Senningerberg, Grand Duchy of Luxembourg, R.C.S. Luxembourg B27900, corporate capital EUR 10.000.000.

Issued in the UK by JPMorgan Asset Management (UK) Limited which is authorised and regulated by the Financial Services Authority. Registered in England No. 01161446. Registered address: 25 Bank St, Canary Wharf, London E14 5JP, United Kingdom.

LV – JPM5374 | 09/12

Follow @JPMAM_UKAdviser on Visit http://am.jpmorgan.co.uk/

Summary Dividend-based investment strategies are currently enjoying a surge in popularity as investors search for reliable income. However, few investors realise that the combination of income and growth has been a powerful source of total returns in emerging markets. The multi-year improvements in corporate capital discipline and governance that we have witnessed over the last decade mean the asset class is now a more sustainable and stable source of income.

Emerging market income ticks a lot of boxes. It offers UK investors an opportunity to diversify away from traditional UK income sources, which are very concentrated, into a global asset class that is diversified across countries, currencies, sectors and companies and becoming an increasingly important part of world equity markets. Diversification benefits aside, we believe the key attraction for a UK investor is the potential for the combination of capital growth and income, which, compounded over long periods, can produce significantly stronger returns.

By offering a powerful mix of dividend income and capital appreciation, higher yielding stocks have consistently outperformed lower yielding stocks with less volatility. The risk-adjusted returns of dividend-based strategies have been compelling across economic environments, with lower downside risk and good participation in gradually rising markets. Accordingly, we believe a well managed portfolio of dividend-paying stocks may prove instrumental to navigating current market challenges and positioning investors for a steadier path to long-term returns.

Finally, developed market uncertainties are clearly creating an opportunity to add to emerging markets. We believe the asset class is a value opportunity awaiting a catalyst, with long-term measures of value such as price-to-book value currently touching crisis level. As a result, now appears to be an excellent time for UK investors to take advantage of the diversification benefits and strong long-term return potential of emerging market income investing.

Richard Titherington,

managing director, is the Chief Investment Officer and is Head of the Emerging Markets Equity Team based in London. An employee since 1986, Richard transferred to the Pacific Regional Group in 1994. He was appointed as a managing director in April 2001 and appointed head of the global emerging markets business in December 2001. Prior to 1994 Richard was a US and international pension fund manager, working in the UK until he transferred to Hong Kong in 1992. Before joining the firm, Richard spent two years as an analyst with UKPI in London. Richard obtained an M.A. in politics, philosophy and economics from Oxford University.