EM income, a new investing approach for a new era

In the latest episode of the Emerging Markets Equities podcast, Nick Robinson is joined by Matt Williams to evaluate the income investing landscape over the last few years. Discussing changes in market regime, dividends and ESG implications. 

Transcript

Nick: Hello, and welcome to the abrdn Emerging Markets Equity Podcast. I'm Nick Robinson from the emerging market equity team. In this podcast series, we explore the factors that underpin our thinking on emerging markets, from key individuals to evolving trends, we seek to answer the five W's: the who, what, where, when, and why, that are shaping investment opportunities in the region. 

In today's episode, Matt Williams is back on the podcast to revisit a topic we discussed nearly two years ago, income investing in emerging markets. Matt has now been with the firm for over 20 years. And he's a senior investment director based in London. Amongst his responsibilities on the team, he's been running the income funds since inception, and they've just celebrated their 10-year anniversary, so he's very well placed to give us his insights on all things emerging market income. Matt, thanks for coming back on, congratulations on the 10-year anniversary.

Matt: Thanks, Nick. It's, it's great to be here.

Nick: Great. Well, let's perhaps start with a question on historical context. If we cast our minds back a couple of years to when you were last on the podcast, we were in quite a different environment back then. Interest rates were very low. I think emerging markets perhaps was starting to raise rates at that stage. But certainly, in more developed markets, they were a fairly distant prospect. There wasn't much inflation around. And many countries were dealing with various COVID waves as new variants were coming. I seem to remember, lots of companies also hoarding cash and reluctant to pay out income. So, if we, if we compare today with where we were back then, how's the environment changed for income investing?

Matt: Yeah, thanks, Nick. Well, I think the most important point here is that we've now got a level playing field for companies and, and a much more stable environment in the sense that now we don't have any more lockdowns. So that means, particularly for Main Street, that they can deal with their customers, and, you know, manufacturing facilities, and end operations are open for business. So that's really the most important difference, it means that companies can plan for the future and have more visibility around where their income stream is going to come in future. And in turn that enables them to, to think about distributing some of that income in the form of a dividend payment.

Nick: Great. And at the end of 2021, we saw quite a significant change in, in the market regime. You know, up until that point, with low interest rates, investors were very much bidding up the prices of growth stocks. But as inflation started to come in, we saw this big shift or rotation more towards value stocks. I mean, given that a lot of income stocks also tend to be value stocks. How did that change the environment?

Yeah, so as you say, the context is that we saw a higher rate of inflation, and we saw different drivers of growth. And I think that's worth exploring, because it caused a significant rotation in the market and, and it created a lot of opportunity for income investing. And there are several reasons why I think those changes are largely structural. And that's very good news for our income approach as we look forward, and essentially, there's no rocket science to this, we're seeing more pricing and more volume growth. And that, of course, is the lifeblood of corporate income generation. 

So, let's explore that. And to do that, I think we need to go back to COVID. And, and understand the, the effects. So firstly, we had a supply disruption, which created upward pressure on prices. Most of the disruption that came from factories halting and transportation bottlenecks have now washed through the system. But when we speak to companies, we're still observing an under investment in a number of important areas of the economy. So, there are reasons to think that whilst we may see a different reason for supply restrictions, that supply is going to remain an underlying pressure on prices going forward. 

And then we had the extra demand that came from stimulus that drove higher volumes, and put upward pressure on prices, as well. And for me, the interesting point here is that we saw a different transmission of stimulus into the economy. And that's because there was a different type of stimulus. So, in the past, we've seen the, the policy of choice to cut interest rates, and for central banks to supply more liquidity into the market. And that has the effect of buoying credit sensitive equities, first. But from COVID and because interest rates were, were at such historic, low levels, and there was already so much liquidity in the market, we had to find a new tool in the in the toolbox. And that came in the form of more government involvement, firstly, in the form of direct government transfers, and secondly, through the form of higher investments. And in my opinion, we're still very early in the use of government directed investments. And that's why I think we're going to continue to see a scenario where we have more breadth of pricing and more volume growth for more companies across emerging markets going forward. 

Now, the consequence of higher prices is that it's appropriate for central banks to mop up excess inflation by raising interest rates, and that has the discounting effect of reducing the worth of future growth. And hence, as you say, there was a shift from growth stocks to value stocks. And I think that, again, is going to continue because I don't see an environment unless we see a major overshoot on interest rates. I think higher interest rates are the other side of the coin, which is higher inflation, that comes from more government investments.

Nick: Yeah, I certainly feel like the market narrative has changed somewhat in the last few months from an expectation that inflation was going to fall back down to 2% or so relatively quickly to one where today it feels like rates are likely to remain higher for longer and inflation a bit higher for longer. Which as you say should benefit the value stocks or the income generating companies where those cash flows are more near dated. 

If we bring it back to emerging markets more broadly, I suppose when you think about emerging markets, or when investors think about EM, it's quite often, you don't really associate EM companies with being big dividend payers. I suppose there's a perception that emerging markets are relatively high growth and growth companies tend to reinvest more in the business rather than paying out dividends. Do you think that's a fair reflection in emerging markets? And how do you think about income investing in the context of emerging markets?

Matt: Well, first thing to say is no, I think it's much more nuanced than that. And it may help to lay out how we think about the income opportunity. 

So, if you visualise the stages of a company lifecycle from when they start life to when they end it, and we break that down into four quadrants. In the first quadrant, a company starts its life, and they have to fight to establish their customer base, investments are higher than the cash flows they, they generate, they're reliant on external funding almost entirely. And if they're successful, then they grow at a very rapid pace, and it's in that quadrant, we actively look to avoid those types of businesses, because we don't think it's appropriate to ask a dividend payment of them. In fact, it could lead to financial stress. Now, the thing I would say about that quadrant is, if you look back empirically, it's a very risky segment of the market, where about 90% of businesses fail to make the transition. 

But those that do move into the second quadrant, and that's where they, they start to have a more reliable customer base, and a more reliable revenue stream that enables them to, to generate internally, internal levels of cash flow, and then they have the choice rather than the need as to whether they want to reinvest that cash flow into future growth and, and how much they want to invest into, into future growth. And it's at this point that we think it's appropriate for those companies to consider and to start mapping out their, their dividend payments. And, and we think that's an important discipline for the executive team to think about. So no, we don't see it as a, as a signal of going x growth. In fact, we would say that there are too many examples of companies focusing on growth, to the detriment of the business overall. If you expand too rapidly, you might reduce your pricing power, or trigger a competitive response from competitors, you may weaken your financials, and you set off a downward spiral. 

In most instances, successful growth companies are the ones that are investing within their means, and using other softer ways to differentiate, such as building brand, and quality of service. And we think the shareholders imposing a discipline of paying a dividend, helps those companies to think about their budgeting and preserving capital to be able to, to pay a dividend, and encourage them to think about alternative ways of differentiating. 

And then there's the third quadrant, where companies are seeing less growth, and it's more appropriate to pay more out to shareholders. 

And lastly, in the fourth quadrant, companies that have gone past maturity, and are moving into a declining phase where they're not investing enough to sustain the existing business. And we wouldn't look to invest in that fourth quadrant either. Because we think those companies, again, by paying a dividend are putting stress on the business overall. So, our playing field is in the second quadrant, and the third quadrant, and we see a lower risk from investing in those types of profitable growth companies, but plenty of opportunity.

Nick: Yeah, that's interesting. So, when you think about the overall market, and in particular those second and third quadrants. How is the proportion of companies within emerging markets now entering those second and third quadrants? So, I guess to get a perspective of when you look back in time, how is the mix of total returns evolving between dividends and price appreciation, and has there been any trend there?

Matt: Yeah, pretty consistently across all markets. If you go back over, for example, about a 10-year period, then clipping that dividend coupon each year accumulates to make a meaningful part of the total returns. And actually over that period. in emerging markets, it represents a hefty, about a 50% portion of the total return of the share price over time. So, it's pretty meaningful. 

And then the interesting part is if you break down the second components of that total return, the price return, it further breaks down into a valuation re-rating and then earnings growth. And we see that 90% plus of the, of the contribution from that segment comes from earnings growth. And that makes sense because a valuation re-rating is really an anticipation of a higher future income stream. So, either you get that income, and the valuation then comes back down, or you don't get that income and the valuation comes back down regardless, but either way, the distribution of an income stream and also the expectation of an earnings growth, which we proxy to be future income growth, drives the total return of share prices. That's the way we think about investing.

Nick: The decade, or just over a decade that you've been running these income mandates, I mean, what have been some of the pitfalls and the things you've learned in terms of how to avoid making mistake?

Matt: Yeah, so if we can keep our focus on the company, lifecycle in those four quadrants, I'd say the, the key pitfall is, is misdiagnosing where a company is. So, you want to invest in companies that are in that second or the third quadrants. But you know, sometimes there are mistakes where they're really not in that category. And I think, for example, investors have, have made that mistake with recently with a number of Digi Tech companies where they've been around for a long time. So, there's a perception that there's a maturity and an establishment to the, to the revenue stream of the business. But when you take away price incentives, I think there's been a discovery that a number of customers are not quite as sticky, as was previously thought. And, and as a consequence, there perhaps, you know, a number of companies are still quite early within their overall development and, and firmly in that first quadrant, but we tend to use our income analysis to try and help avoid some of those categorisation pitfalls, in much the same way as a doctor would take a blood sample and analyse that to understand what's happening in the key organs of the body. We would look at the income being generated in companies to kind of shine a spotlight on the, on the various financial statements and to build up a richer interpretation of, of what's going on.

Nick: Right, and what about ESG issues related to running an income mandate in that, you know, historically, a lot of the high dividend payers tend to or quite a lot of them tend to be in sectors where there's a bit more ESG risk, be it materials companies or utilities companies. Is that an issue that you have to keep front of mind?

Matt: We think about environmental, social and government governance issues as inputs into our research process, as we try to understand the likely future income stream of the business and the risks and the opportunities associated with that. So, if we take an example of carbon emissions, there is a clear cost that we're identifying to the natural world from emitting excess pollutants into the atmosphere. And we need to find the, you know, an appropriate incentive price for companies to be able to deal with those costs in a constructive way. So we think a lot about those costs and the ability of companies to manage for risks, such as that, but taking that example, and perhaps put a different way. I tend to think most companies want to do the right thing by all of their stakeholders, the issue is invariably whether the end customer is willing to pay for those extra costs, and to, and to encourage the associated investments. And I think we're going through that process of discovery today. And, you know, it's really fascinating to, to analyse and work your way through that, but I perhaps wouldn't describe those companies as, as an evil, I think it's an outcome of not having the right pricing for their products and services.

Nick: Not having the right pricing - in terms of what? Could you expand on that a little bit?

Matt: Yeah, so I think if you, if you take, for example, the copper price, customers have not been willing to pay a price that enables companies to invest sufficiently in, in paying their employees to a sufficient level to, to investing enough into the safety and security of their mining operations to the extent that they would like, to filling government coffers, to enable them to have options to redistribute within society. And I think we need to reach a copper price that incentivises some of those investments so that we don't get the disruptions from strike action. And we don't get the risks of, you know, catastrophic failures within mining operations. And we don't get a conflict with government that again, leads to potential, you know, conflict and confrontation.

Nick: Yeah. Okay. Thanks. That makes sense. Yeah, certainly an argument for higher prices leading to better ESG standards within companies. So, that’s interesting. 

Looking forward, now we are in the later phases of the rate cycle, albeit rates may stay higher for longer. And there probably is the prospect of some rate cuts ahead at some point. How does that change the outlook for income? Do you think as rates fall again, investors desire for income is likely to increase again, so you'll see demand for the product?

Matt: Yeah. Nick, going back to one of the earlier points we talked about, I think the, I think an important driver here is that the tools in the policy toolbox have changed somewhat, we may get minor adjustments to level of interest rates. But I think the driver, key driver of policy, if we approach a downturn and as we steer through future up turns is that there's going to be more government. And I think if you look across the economy, there are so many areas where governments are identifying the need to invest, to make our economies fit for purpose. And there are so many reasons they're finding to invest for the, for the betterment of society overall. So whether that means, nearshoring investment for which I think there are a lot of emerging market countries that, that stand to benefit or onshoring investments, the need for more energy security, water security, the list is growing by the day, and it's those policy initiatives that I think are going to drive this pricing and volume effects and keep interest rates and inflation overall, at higher than historic levels. So those are the, those are the reasons I think that what we've seen in the recent past is going to continue for actually for many years to come.

Nick: Great. Well, thanks very much for that Matt. That feels like a good place to draw the podcast to a close. So thanks a lot, Matt, for being the guest on this one. It's much appreciated.

Matt: Great. Thanks for having me, Nick.

Nick: Great. And thanks to everyone who took the time today to listen in. If you enjoyed today, then please download our other podcasts from our website or wherever you normally get your podcasts. Watch out for our next episode and tune in.