Jesse Sherman of Renaissance Asset Managers -
"Do you know the only thing that gives me pleasure? It's to see my dividends coming in." John D. Rockefeller
Rockefeller's quote is a simple recasting of the old adage "cash is king". While many issues are cited as reasons for the discounted valuation of Emerging Europe - from political instability, to uncertain taxation, to poor corporate governance - the lack of positive cash flow has been a core driver of the value gap.
Given tremendous growth opportunities, most companies in Emerging Europe have traditionally needed high leverage to fuel investment and delivered negative or insignificant free cash flow. Even when companies have historically generated strong positive cash flow, minority investors rarely saw the benefits in the form of dividends. At the market peak during 2007, the MSCI Eastern Europe index yielded 1.7% vs. 2.0% for the S&P 500 and 3.0% for the Euro Stoxx 600.
But things are changing. Emerging European companies over the past few years have benefited from strong commodity prices, delivered positive free cash flow, shored up their balance sheets and raised dividend payouts. As a result, the MSCI Eastern Europe Index in 2011 has a 3.1% expected dividend yield, well ahead of S&P 500 stocks at 2.1%, and closing the gap with Euro Stoxx 600 constituents at 4.0%.
Some 35-40% of MSCI Eastern Europe stocks are expected to pay dividends of 3% or more in 2011, a higher proportion than the S&P 500 (26%), and closer to the Euro Stoxx 600 level (58%).
Good news, but is the trend sustainable? We believe it is. First and foremost, it has become clear that governments, which remain significant shareholders in many of the companies, need cash to meet social obligations, and the increasingly preferred method for generating capital are dividends - a trend already visible in Poland and Russia. With future privatizations planned, sustained or improving dividends are likely.
At the corporate level, balance sheets remain largely deleveraged. A subsequent two or three years of growth and investment has also resulted in capital expenditures either peaking or peaked, while operating cash flow is now large enough to fund most of future investments and sustain higher growth rates than are seen in the developed world.
It is a paradigm shift in emerging markets: positive cash flow generation has only just begun, as traditionally high yielding global sectors, like retailing or utilities, are either paying negligible levels (such as Russian food retailer Magnit with 0.3%) or are on the cusp of beginning to pay out (as is the case with Russian utility companies OGK-4 and OGK-5).
The highest dividend payers currently are companies from traditionally high-growth sectors or cyclical stocks. Russian broadcaster CTC Media and Czech coal miner New World Resources are both expected to pay dividends yielding more than 6% for fiscal year 2011. The clearest signal of this change is Gazprom management increasing its dividend payout to a 4.5% yield on par with global peers - more than triple what it paid out in 2009.
Despite the stronger macro picture in emerging markets and supportive commodity prices, the valuation chasm between Emerging Europe and developed markets has only widened, to a 51% discount versus the S&P and 42% versus the Euro Stoxx versus historical averages of 35% and 23%, respectively.
While developed market price/earnings ratios are only 6% below their five-year averages, in contrast Emerging Europe at a 6.2x P/E, is 30% below historic levels, even as the dividend picture has changed.
A strong platform for Emerging European stock performance exists given the backdrop of strong balance sheets and rising dividend yields. In our view Emerging European equities are a very attractive proposition at this time as all of the elements are in place for the unwarranted valuation discount to narrow.
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