By Martin Hutchinson

If an economy and its markets are sound, income investors can both reduce risk and improve returns

If you’re a stock investor looking for income, you’ve got a problem at the moment. Namely, the potential loss of capital. With the U.S. market at an all-time high and yields currently depressed, the risk/reward ratio is exceptionally unattractive. But far from making weak bets, or giving up entirely, there are many markets around the world that are still selling below or a little above where they were a decade ago. If these underlying economies and markets are sound, income investors can both reduce risk and improve returns.

Where the Dow Should Be Trading Today

Let’s deal with the U.S. market first — one that’s proven to be the second-best performer among all developed markets over the past 10 years. (The top spot, by the way, goes to Denmark, according to the MSCI indexes, which measure returns in dollars.) Now, admittedly, the U.S. only notched a total return of 7.9%, compared to Denmark’s 11.3%, but the U.S. market has nevertheless hit an all-time high, with seven record closes for the Dow on successive days and the S&P 500 trading at a price-to-earnings ratio of 25.1 times, far above its long-term average of 15.6.
Look back even longer, and compare the valuation to February 1995 — when Alan Greenspan made a momentous change in monetary policy that set off the late 1990s stock market boom — and you see that on the day of the change, the Dow was trading at just 4,000.
If you assume that stock prices should grow approximately in line with the economy, then grossing up that level by the 142% increase in nominal gross domestic product (GDP) (including inflation, as well as real growth) since then would suggest that the Dow should trade at 9,700 today, rather than today’s actual level of around 18,600. Whichever way you look at it, U.S. stocks in general are currently risky and low-yielding – a bad deal for income investors.
However, there are many other countries that haven’t shared the U.S. stock market boom… yet have enjoyed attractive economic growth over the last 10 years.

Bet on These Two Nations

Among developed countries, Western European nations have scored the lowest returns over the last 10 years. Austria, Ireland, Italy, and Portugal have all posted returns lower than minus 5%. And this includes dividends. A truly pathetic performance. Outside Western Europe, Japan and Canada have recorded the lowest returns — 1.6% and 3.7%, respectively, including dividends. Of these possibilities, Austria looks attractive, with a projected growth rate of 1.3% this year and next year (according to The Economist’s forecasters), a balance of payments surplus, and a budget deficit that’s a modest 1.9% of GDP. The iShares MSCI Austria Capped ETF (EWO) is a relatively small fund, with net assets of only $59 million. But with a 2.3% yield, an average 12.6 price-to-earnings (P/E) ratio in its portfolio of companies, and a 0.48% expense ratio, it’s an attractive way into this market. Among emerging markets, there’s a much larger gap between the standouts and the stinkers.
Take the Philippines, for example — one of my favorite markets. It’s notched annual returns of 16.9% per annum including dividends over the past decade. That’s what 6% economic growth will get you. The Philippines was poorly rated 10 years ago, due to its poverty and government corruption, but it’s considerably richer today, and its governments are at least somewhat less corrupt.

Dividend Yield by Country | Source:

Dividend Yield by Country | Source:

Dodge the Dogs… Except This One

By contrast, Greece has bombed. Its compound annual “return” — including dividends — over the past 10 years is negative 26.7%. In other words, if you’d invested $100 in the Greek market in 2006, you’d have just $4.33 now — and that’s without any currency devaluations, since Greece uses the euro. Needless to say, the lowest 10-year returns among emerging markets are probably to be avoided, as they appear exceptionally risky. Apart from Greece, the dogs include Russia at minus 4%, which has corruption and autocracy problems. Still Poland, with a compound return of negative 2.6%, does look attractive, with growth estimated above 3% in 2016 and 2017, and both its current account and budget deficits around 2% of GDP. The iShares MSCI Poland Capped ETF (EPOL) has a modest 12.7 P/E, an expense ratio of 0.62%, but a yield of only 1.7%.

Is This Market Really “Emerging”?

One market classified as emerging, though in my view should be included among the developed markets, is South Korea. Yes… it’s only returned 4.5%, including dividends, over the last 10 years and minus 1.5% over the last five years – well below the U.S. market. However, South Korea is a stable democracy, with near-Western living standards and a growth rate estimated at 2.5% in 2016 and 2017 (higher than the U.S.), a massive current account surplus, and a small budget surplus. The iShares MSCI South Korea Capped ETF (EWY) has a P/E ratio of only 10.6, a yield of 2.3%, and an expense ratio of 0.62%. By buying foreign stock markets that are less richly valued than the U.S. market, and have soared less over the last few years, income investors can achieve higher returns.

Most importantly, the trick is to diversify your portfolio and reduce risk

Martin Hutchinson was an international merchant banker in London, New York, & Zagreb and a weekly column writer at Bear’s Lair.

This article was originally published on Wall Street Daily.

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Posted by The Indian Economist