URTH - VWO: High Dividend Yield To Drive EM Outperformance

Summary

• The higher yield on the FTSE Emerging Markets index suggests the VWO should outperform the MSCI World by almost 2 percentage points annually assuming no valuation changes.
• The higher dividend yield reflects the significantly lower P/E ratio on EM stocks, which trade at a 40% discount to the MSCI World on an unadjusted basis.
• There is also the potential for changes in valuations to provide additional support to EM stocks on a relative basis.
• If the dividend yield on the FTSE Emerging Markets index and the MSCI were to converge back to the same level, all else equal, this would either mean a 40% decline for the MSCI World or a 70% rise for the VWO, all else equal.

Emerging market stocks continue to underperform developed market stocks, and this underperformance should pave the way for long-term reversal as dividend yields in the former are now significantly more attractive. This higher yield should see EM outperform the MSCI World (URTH) by around 2 percentage points annually, with significantly more returns resulting from valuation mean reversion. I therefore remain long the Vanguard FTSE Emerging Markets ETF ( VWO ) which offers a low-cost way of benefitting from a relative revival in EM stocks.

The VWO ETF

The VWO tracks the performance of the FTSE Emerging Markets index and offers exposure to large-cap EM stocks with a very low expense ratio of 0.1%, which compares favorably to the 0.7% charge for the iShares MSCI Emerging Markets ETF ( EEM ). China has a higher weighting in the VWO, comprising 33% of the index versus 27% in the EEM. This largely reflects the absence of Korean stocks in the index, which contrasts with the EEM's 12% weighting. The absence of Korean tech giant Samsung also means a slightly lower weighting towards Technology. The VWO pays a dividend yield of 4.0%, which is slightly higher than the trailing yield on the underlying index but roughly in line with the forward dividend yield.

Higher Dividend Yield Reflects Relative Undervaluation

The recent recovery in European stocks in particular has seen the dividend yield on the MSCI World fall to just 2.2%, while the yield on the FTSE Emerging Markets index has risen to 3.4%. On a forward-looking basis, the EM dividend advantage is even stronger. The forward dividend yield on the FTSE Emerging Markets index is up at 3.8%, versus just 2.2% for the MSCI World, marking an impressive 40% discount.

This superior dividend yield is not merely a reflection of higher payout ratios among emerging market stocks, but reflects a deep valuation discount. The trailing P/E ratio for example for the EM index sits at 13.9x versus 17.4x for the MSCI World. The valuation case for EM is even stronger when looking at unadjusted earnings. When we include so-called one-off gains and losses, the diluted P/E ratio on the EM index falls to just 12.4x, while the ratio on the MSCI World rises to 20.3x. This makes the FTSE Emerging Markets index almost 40% cheaper than the MSCI World, fully explaining the higher dividend yield.

Higher Yield And Potential Valuation Mean Reversion Suggests Significant EM Outperformance

A 1.6 percentage point spread may not seem particularly important as EM stocks have long has higher yields relative to DM stocks yet have managed to outperform thanks to strong dividend growth and rising valuations. However, after a surge in US developed market dividend payments over the past decade, most notably driven by the US tech sector, future dividend growth for both EM and DM stocks likely to be capped by nominal GDP growth. Furthermore, there is also the potential for changes in valuations to provide additional support to EM stocks on a relative basis. If, for instance, the dividend yield on the FTSE Emerging Markets index and the MSCI were to converge back to the same level, all else equal this would either mean a 40% decline for the MSCI World or a 70% rise for the FTSE EM index. This is the beauty of buying stocks that are undervalued. Not only should investors expect to see EM returns exceed those of the MSCI World due to higher dividend returns, but there is also scope for capital gains should valuations mean revert.

Summary

The VWO is highly attractive on a relative basis as the index offers a dividend yield that is significantly above that of the MSCI world. This higher dividend yield reflects relative undervaluation, with the unadjusted P/E ratio trading at a 40% discount to the MSCI world. Based on the forward dividend yield differential, investors should expect to receive around 1.6% higher annual returns in the VWO relative to the MSCI World, but the actual outperformance is likely to be much higher due to the potential for valuation mean reversion.

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