Foreign Stock in Dividend

FOREIGN STOCKS

Some dividend payers, particularly in emerging markets, can offer very attractive yields, especially in comparison to their American counterparts.

In late 2011, while quality American companies were trading with yields around 3% to 4%, many emerging market and beaten-up European equities were paying double those yields.

It’s important to consider why emerging market stocks may have a higher dividend yield. Remember, Wall Street doesn’t just give money away. Two equal stocks will typically not pay dividend yields that are so wide apart that one will be one and a half to twice that of its peer.

If company A is paying a yield of 7% and company B is paying 3.5%, it’s because company A is riskier or Wall Street believes it’s riskier. Great investors make lots of money when they can identify those companies that are mispriced because Wall Street is mistakenly scared of a stock or underestimated its performance.

The same is true when it comes to dividend yields. You’ll want to find those companies whose yields are high compared to similar American companies, because the Street has mispriced the stock.

But it is very important to realize that the higher yield typically involves higher risk. It doesn’t mean you shouldn’t take that risk, but you definitely need to be aware of it.

One Lump or Two?

Wall Street analysts have their own language. They say things like “Can you give some more granularity on that?” when they’re asking a CEO for more details on a topic, or they might ask for more “color” on the quarter.

One of my favorite terms is “lumpy.” It means inconsistent. A company’s profits might be described as lumpy if one quarter has earnings of $1 per share, the next has only $0.20 in earnings, and the following quarter EPS is $1.05. Sometimes that’s due to a sales cycle or simply when a big contract gets signed/paid/recognized.

I’ve extended “lumpiness” to dividend payments as well. Foreign stocks often have lumpy dividends. They might pay $1.65 per share in year 1, $1.32 in year 2, $1.77 in year 3 and $1.41 in year 4.

American companies typically try not to have the dividend flying all over the place like that. They do their best to keep the dividend consistent. If management is concerned that it might have to cut the dividend in the future, chances are it won’t raise the dividend the year before, so that the change doesn’t appear to be a reduction in the dividend.

When it comes to companies located overseas, particularly in emerging markets, the dividends can vary widely from year to year. Currency fluctuation can play a big part in that. In the local currency, a company may pay a consistent dividend. But if that currency moves 10% per year against the dollar, an investor in the American depositary receipt (ADR) may get $2 per share in dividends one year and $1.80 the next year, all while the company actually shelled out the same amount in its local currency.

American depositary receipt (ADR): An instrument that trades on a U.S. exchange that represents shares (often one share) of a foreign stock. The ADR is denominated in U.S. dollars while the actual foreign stock is priced in the currency of the exchange where it trades. An owner of an ADR has the right to convert the ADR into shares of the foreign stock, although few people actually do.

For example, Chilean bank Corpbanca SA (NYSE: BCA) paid out dividends of Ch$51 billion in 2008, Ch$56 billion in 2009, and Ch$85 billion in 2010 (Ch$ = Chilean peso). An investor in Chile would have received Ch$0.22 per share in 2008, Ch$0.25 in 2009, and Ch$0.37 in 2010.

However, because the peso appreciated in 2009 from where it was for most of 2008, U.S. investors actually saw their dividend decline to $0.49 per ADR from $0.61. In 2010, when the peso fell, U.S. holders of the ADR received $0.86.

As you can see in Table 11.1, in 2009, Corpbanca actually paid more in total dividends and more per share in dividends, yet investors in the ADR received less per unit because of the currency appreciation.

Table 11.1 Corpbanca Dividend History

This is an important concept to understand because it impacts your dividends. Let’s make up an example that will be easy to grasp.

The only currency accepted in Marc Lichtenfeld’s Authentic Italian Trattoria is the Lichtenfeldian dollar (L$). At the time I go public and sell stock, it is trading at parity with the U.S. dollar: L$1 = $1. The stock is also denominated in Lichtenfeldian dollars.

Let’s assume that one ADR represents one share of stock.

I declare a dividend of L$1 per share. Because the Lichtenfeldian dollar (also known as the Lichty) is trading at a 1:1 ratio with the U.S. dollar, ADR holders will receive $1 per share.

The following year, due to the success of my baked ziti, the Lichtenfeldian dollar appreciates to $2 for every L$1.

I continue to pay L$1 per share in dividends. However, because the Lichty is now worth two U.S. dollars, ADR holders will receive $2.

In year 3, after a food reviewer gets a nasty case of the heaves following a bad batch of clams casino, the Lichty plummets to $0.50 for every L$1. I continue to pay a dividend of L$1 per share, but now that equals $0.50.

So over the course of three years, I paid out L$1 per share in each year yet the holders of the ADR saw their distribution fluctuate between $2 and $0.50 because of the currency swings.

Lumpy Perpetual Dividend Raisers?

This lumpiness in dividends received by ADR holders makes it difficult to find foreign Perpetual Dividend Raisers.

Dividend programs usually are carefully managed. When earnings and cash flow are somewhat predictable, executives will have a strategy for how they will distribute dividends and whether there will be a growth plan. If there is enough excess cash to grow the dividend each year, usually there will be a target growth rate.      

Even if a foreign management team has that kind of dividend strategy in place, what ADR holders will receive is out of their control due to the movement of currency prices.

A company could raise its dividend 5% in a year, but if the currency depreciates against the dollar, ADR holders could see a lower payout, even with the rise in the dividend.

Therefore, it is often very difficult to find foreign stocks that qualify as Perpetual Dividend Raisers. Not only does the company have to cooperate but so does the currency market. And the chances of the dollar steadily decreasing over another currency year after year are small.

This is not a political or economic argument. It’s not that I’m especially bullish on the dollar, it’s just that markets, particularly currency markets, seldom move in one direction. Over many years, there might be a trend. The dollar may depreciate over a particular currency over five or ten years. But it’s highly unlikely the currency’s change will be a straight line.

And that fluctuation could impact a company’s ability to be called a Perpetual Dividend Raiser. If the dollar does in fact depreciate and the company is raising dividends, it could turn out to be a nice investment over the years. However, it will be far less predictable than other types of stocks that we’ve been talking about in this book.

If you want to be assured that you’re getting a greater income stream year after year, a foreign dividend payer might not get the job done.

Another issue when it comes to foreign dividend payers is the frequency of the dividend payments. Investors in American companies are used to receiving a quarterly dividend. Foreign companies often pay only once or twice a year.

For investors who rely on dividend income, that means just one or two big checks coming in rather than four smaller ones.

It’s not a big deal for investors who don’t need the income, but for those who do, the timing can be a problem. Even for investors who are reinvesting the dividend, the once-a-year payment can impact total return negatively.

When you reinvest a dividend that you receive four times a year, you’re spacing your investment out over four periods at four different prices. It’s very similar to dollar cost averaging, where money is invested over periods of time.

If you’re receiving only one payment a year, all of that money is going back into the stock at once. If the stock runs up in anticipation of the dividend, you end up reinvesting the entire year’s dividend at a high price.

A stock’s move before its ex-dividend date is not unusual due to something called dividend capture.

Dividend capture: Buying a stock just prior to its ex-dividend date (the date in which a new investor is not entitled to the most recent dividend) in order to capture the dividend and then selling the stock shortly afterward.

When investors engage in a dividend capture strategy, the idea is to own the stock just long enough to be paid the dividend. Then they move on to the next stock (although some might hold the stock for 61 days in order to avoid paying a higher tax rate).

Stocks that pay a high level of dividends are particularly attractive to users of the dividend capture strategy. A stock that pays a large dividend only once per year would definitely be on their radar.

This strategy is important because if enough buyers are interested in getting in right before the dividend is paid (whether they’re dividend capture investors or they plan on being legitimate long-term holders), the stock price will advance as more buyers come into the stock.

That’s a problem for the investor who is reinvesting dividends once per year. If the stock runs higher every time long-term investors are going to reinvest their dividends, their returns are going to be far lower than in a stock that isn’t attracting this attention right before the dividend is paid.

The dividend capture strategy isn’t directed just at foreign stocks. It can and does happen to American companies as well. But with four periods throughout the year and the fact that the dividend is broken up into four pieces, the likelihood of being severely impacted is lower than if you’re invested in a stock that pays out a 6% dividend once a year.

Other Risks

When you invest in a company that is located and trading in another country, you take on additional risks, such as political, economic and regulatory.

Although American regulators and auditors are by no means perfect, as investors who lost money in Enron or with Bernie Madoff will attest, the system does offer a reasonable amount of assurance that reported financial results are legitimate. Someone who is sharp and committed to defrauding investors will likely succeed, but that is by far the exception, not the rule.

In some other countries, investors generally do not know how good the regulators and auditors are. As an average investor, you may do your due diligence on a Chilean telecom company, but, in truth, you have no idea how thorough regulators and auditors are in Chile. They may be terrific—the best in the world, for all you know. But that’s the point. You don’t know.

So when a foreign company reports financial results, there has to be a certain level of trust—even more so than with an American company, especially if the country we’re talking about is an emerging market.

You might think that’s ethnocentric to say, but it’s the truth. Countries with long-standing stock markets, such as England and Australia, generally have solid accounting practices and rules. On the other side are countries like China, which are notorious for hosting shell corporations and companies that cook the books.

If that’s not scary enough, in certain countries you run the risk of political or economic upheaval. As I write this, Argentina is going through a very high level of inflation. Although the rate is being reported officially as under 10%, most people say it’s really above 20%.

As a result, Argentina may eventually (or by the time you read this may already have) devalue its currency, which will hurt its businesses and their ability to pay dividends.

Some countries could have political upheaval, which may impact a company’s ability to grow profits and dividends. Maybe it sinks the share price of a great company, allowing you to buy more shares cheaply, before it eventually comes back in favor. Or perhaps it never comes back because the new leader of the country is corrupt, antibusiness, whatever.

Now that I’ve probably scared you out of investing in anything other than the bluest American blue chips, let me tell you why ADRs can be a good addition to your portfolio.

Because of all of the various factors that can impact your yield and return, you’re often compensated for that risk in the form of a higher dividend yield. As I explained earlier, a solid dividend in the United States right now is 3% to 4%. In emerging markets, you can find high-quality companies paying 5% to 6%.

If you’re invested in the right company in the right market, you can obtain high yields with significant capital gains as well.

Any financial advisor worth his khakis will tell you to diversify your portfolio. You should have small caps, large caps, mid caps, American companies, and international companies, including those in emerging markets.

A portfolio of dividend stocks is no different. Although there are some additional risks, you also take extra risk by not diversifying.

For example, in 2008, the S&P 500 fell 37%. Anyone who was invested in the Tunisian stock market (and who wasn’t?) saw a gain of 10%.

That’s obviously an extreme example, but it illustrates the point that investing in other markets can produce gains when the rest of your portfolio is going down.

You need to do your homework when investing in a foreign dividend payer and be sure you understand the additional and unique risks for that particular stock in that particular country. But if you are aware of the risks and the market is adequately compensating you for them, they can be an important part of your portfolio. I would just caution that you don’t chase yield and overweight your portfolio with these kinds of stocks.

Treat these stocks like dessert. As we tell our kids, ice cream is a sometimes food. Most of what they eat consists of fruit, vegetables, protein, and grains. And then sometimes they get ice cream. Your dividend portfolio should consist mostly of Perpetual Dividend Raisers that qualify for the 10-11-12 System. But it’s perfectly fine— in fact, it’s recommended—to have a sprinkling of foreign dividend payers in there, as long as you’re aware that they will not likely be Perpetual Dividend Raisers. But that extra yield you get may make it worth your while.

Summary

• Many foreign dividend payers currently have considerably higher yields than their American counterparts.
• Foreign companies are usually not classified as Perpetual Dividend Raisers because of currency fluctuation.
• The higher yields are compensation for higher political and economic risk.
• Many foreign dividends are paid only once or twice a year.
• You should have been invested in the Tunisian stock market in 2008.