Dividend Growth Opportunities in Asia ex Japan
Technology and health care companies are not only at the forefront of several long-term, secular trends, but also accounted for some of the fastest dividend growth in the last decade.
In the last three years, dividend payments by members in the MSCI AC Asia ex Japan Index have grown from US$281 billion in 2017 to approximately $323 billion in 2020.1 We believe the broadening of the region's capital markets, combined with improved liquidity and an increasing focus on corporate governance, has contributed to a sharp increase in the number of companies paying both attractive and rising dividends. In the past many of the largest dividend-paying companies in Asia were in the financial and energy sectors. Today while financials still comprise the largest constituent of dividend payers, Asia is home to much more diversified sources of income. No single sector dominates the region in terms of dividends paid. Consumer-related sectors, such as information technology (IT), health care and consumer discretionary accounted for the fastest dividend growth over the last decade. On the surface, sectors such as IT and health care appeal in terms of their long-term capital growth prospect and seem unlikely candidates for a dividend strategy. Asia, however, has a deep rooted dividend culture. Today many companies in the region still have the original business founders as controlling shareholders. For them, dividends often represent a significant source of income and cash flow.
Dividends in technology and health care
The IT sector has certainly caught investor attention year to date. In our view, the COVID-19 outbreak has accelerated a structural transition from offline to online economic growth that was already taking place. Technology is at the forefront of several long-term, secular trends that are driving growth in the region. From e-commerce to online gaming, we see technology playing an ever-increasing role in people's lives. With it comes a multitude of potential investment opportunities in both hardware and software. Semiconductor manufacturers have long featured prominently in our dividend strategies, but the portfolios also have exposure to communication towers, data centers and mobile gaming companies. It's important to look beyond large-and mega-caps to capture Asia's technological evolution: Less well-known small-cap companies exposed to Asia's cloud build out and key component providers to 5G technology upgrades can also potentially offer attractive dividend growth opportunities.
Most technology opportunities are found in Taiwan, South Korea and China. Taiwanese listed companies have a regulatory incentive to pay part of their earnings in the form of dividends. This is why many Taiwanese IT companies offer a substantially higher dividend yield than the wider MSCI Asia ex Japan Index average. Opportunities are not only confined to the mega-cap stock. In our opinion, there are many interesting opportunities in the mid-cap and especially small-cap areas which we believe offer attractive dividend growth. We are increasingly finding opportunities in China A-shares. Continuing trade tensions between the U.S. and China are driving the growth of indigenous technology businesses, and we believe China's goal to be less reliant on U.S. imports could also benefit Taiwanese and South Korean companies who will look to build market share in China in the absence of U.S. imports. Regardless of the outcome of future trade negotiations, we believe the cloud business and 5G upgrades could propel multi-year growth for many of these tech companies. When it comes to health care opportunities, many investors may still have the outdated perception that Japan is the only market with globally recognized companies in Asia. This makes it interesting in terms of investment as demographics, rising income and innovation are contributing to the growth of this young sector. Asia's consumers will continue to play an important role in the growth of health care-related services, with patients seeking better quality care and services as incomes rise. For companies to be considered for our dividend portfolios, we assess both their “ability” and “willingness” to pay dividends. Fast-growing companies are only relevant if they generate a healthy amount of cash earnings. Therefore biotechnology companies that are still in the early phase of research and development are unlikely to make the grade. Instead we focus on companies that are already generating positive earnings and free cash flow. We believe many opportunities can be found in China where a structural shift from expensive multinational imports to domestic products could provide a tailwind for companies such as medical device companies.
We also see opportunities in contract research organizations (CRO) companies. China has the largest number of STEM (science, technology, engineering and mathematics) graduates in the world, and CROs are capitalizing on China's research and engineering talent pool at a lower labor costs compared to developed markets. As a result Chinese CROs have been able to gain global market share. Hospitals are another area that may become interesting in future as many pay dividends once they reach profitability.
Today the nascence of Asia's health care sector somewhat limits the opportunity set, but over time we expect more and more companies to be listed on the markets. Health care exposure across our dividend portfolios is likely to change over the years alongside, moving from fast-growing smaller companies that may be potential emerging champions to also include more mature businesses that may offer attractive and stable dividend yields.
Asia's dividend culture preserves yields
We have not seen any announcements of draconian dividend cuts in the IT and health care sector so far. 2019 was a strong year for these companies, but technology companies are slightly more cautious about their 2020 expectations. We believe they are likely to remain resilient. For many Asian companies dividends have remained the predominant vehicle to return any kind of excess cash to shareholders. Unlike in other regions, share buybacks remain underutilized.
When markets sold off in March, dividend-paying stocks as a whole were unduly punished as worried investors made no differentiation for companies that preserved their dividends. This provided an opportunity to buy companies with historically strong dividend growth at lower valuations than typical growth companies. In our view, it further illustrates the importance of assessing the fundamentals of a company.
In recent months, valuations in technology, consumer discretionary and health care sectors have been steadily creeping higher while other sectors lagged behind. In some cases, the market appeared to get ahead of itself, making price to earnings ratios (P/E's) appear significantly stretched before correcting in September. We believe the fundamentals of companies in those sectors remain intact across our dividend portfolios and should continue to provide attractive long-term investment opportunities.
Looking ahead we see two potential risks that could have major market implications. First, the risk of the coronavirus resurgence and its impact on the re-opening of global economy could continue to dictate short-term market volatility. Second, the downward spiral of U.S. – China relations has the potential of upending the decades'-long geopolitical stability, a crucial factor behind the booming of Asia economy.
Notwithstanding, improving signs of economic recovery, led by China, are building a solid fundamental foundation to sustain the current equity rally. In the current environment, we believe our dividend investment approach of balancing stable dividend payers with fast-growing dividend growers continues to offer a sensible way of tapping Asia's long-term growth potential.
Yu Zhang, CFA
1 2020 dividends by index members as of April 2020; Sources: FactSet Research Systems, MSCI
Dividend Yield: Dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock.
Earnings Per Share (EPS): Earnings Per Share (EPS) is the amount of annual profit (after tax and all other expenses) attributable to each share in a company. EPS is calculated by dividing profit by the average number of shares on issue.
Free Cash Flow (FCF): Free Cash Flow (FCF) is a measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base.
MSCI All Country Asia ex Japan Index: The MSCI All Country Asia ex Japan Index is a free float— adjusted market capitalization—weighted index of the stock of markets of China, Hong Kong, India, Indonesia, Malaysia, Philippines, Singapore, South Korea, Taiwan and Thailand. It is not possible to invest directly in an index.