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Looking for income? Three reasons to go global

By adopting a U.S.-centric approach to income, investors may unwittingly heighten their exposure to certain key risk factors and limit their diversification.

The income problem may last for decades

To some, the evolution of demographics is like watching paint  dry. To fiscal planners, the image that may come to mind is more  of a slow moving train wreck. Irrespective of one’s perspective,  the aggregate statistics are largely indisputable. In the U.S.,  the next couple of decades will see substantial increases in the  number of retirees, with the total almost doubling from 2012  to 2050.

This phenomenon is not unique to the United States, as dependency ratios are set to rise throughout much of Europe  and Asia as well.
With many millions of households worldwide shifting from  the accumulation phase of the investment lifecycle to the distribution phase, there is likely to be continued strong  demand for income-generative assets.

With this strong and rising underlying demand, income  generative assets may continue to display premium valuations  for decades and income investors may be vulnerable to new  product issuance that seeks to exploit the global income need.  One example of this in the United States was the Master-  Limited Partnership (MLP) bubble of 2014, where volatile  energy businesses were able to raise capital at high valuations  by portraying themselves as stable income sources.

The importance of looking beyond the U.S.

While the United States  offers very deep and rich  capital markets, U.S.  equities are deficient  in many respects as a  hunting ground for income  investors. As a result,  income seekers can suffer  some unintended and potentially adverse consequences by focusing too narrowly on  the U.S. We would like to highlight three key contrasts between  the U.S. and the rest of the world.

#1 – A numbers game

Simply put, the proportion of business that pay high  dividends is much higher outside the U.S. Almost 40% of the non-U.S. MSCI World stocks pay 3%  dividends or more, compared with barely 20% in the United States.

When viewed in absolute numerical terms, the contrast is even  more striking. There are simply many more opportunities to find  attractively valued income streams outside the United States.

The reasons for this discrepancy are debatable, but one  explanation could be the historical tax advantage that capital  gains enjoyed in the U.S. over dividends. Although the  introduction of qualified dividends in 2003 addressed this disparity, buybacks continue to be used as a prominent way to return capital in the U.S.

#2 – Geographic diversification is industry diversification

In addition to the numerical disparity, the composition of  dividend payers varies considerably by geographic area. In  particular, many of the U.S. high dividend payers tend to  be clustered in “bond proxy” sectors where investors  may be exposed to significant interest rate risk.

Traditional bond proxy sectors (such as REITS, Utilities and Telecommunications shares) along with defensives (such as food and tobacco firms) make up more than half of the U.S.  high dividend payers, versus only one quarter of the dividend payers outside the U.S.

When one adds in the energy sector (which includes the pipeline stocks and MLPs mentioned above), the total grows to over three quarters of the U.S. dividend universe.

The picture is the almost mirror image outside the U.S., where  there are many more cyclical, industrial and commercial  businesses offering attractive yields.

To summarize, for income investors, geographic diversification is industry diversification.

#3 – Cultural conservatism

Another possible reason for the disparity in income payers is the preponderance of family-controlled public companies outside  the U.S. Controlling family shareholders often rely on dividend  distributions to meet their liquidity needs, creating alignment with income investors. These businesses often tend to be conservatively managed and eschew financial leverage.

Conversely, in the U.S., public markets have been shaped by  the corporate raiders of the 1980s and the activists of today  who favor debt-funded buybacks as a way to crystalize returns quickly. If timed well, these measures can indeed create  value. However, the levered capital structures they leave  behind, may not be suitable for income investors with  more subdued risk appetites.

A value filter is key
Income investors may continue to face an environment where  yield is in high demand and the financial industry is eager to  sell it. A value approach focused on a margin of safety can help  identify when to say no to income and differentiate between  attractive cash flow and “yield traps.”