Insights on Income: Foreign Markets are a Necessary Profit Play for Today's Income Investor

By Martin Hutchinson
Contributing Editor
Back in the middle 1980s, income investing for U.S. investors was pretty simple. Inflation was around 5% - roughly the same as now - but U.S. government bonds were paying close to 8%, and without going into high-risk debt issues you could find 9% with very little difficulty.

If you were an income investor, to balance those high yields, you also had to have capital appreciation, so about half your portfolio would be invested in U.S. common stocks - which, thanks to their dividend payouts, yielded a good 3%-4% themselves. Even after you paid Uncle Sam, a portfolio such as this one would have easily thrown off 5% of its value in income, and allowed you to keep up with inflation as stock prices generally rose.

Clearly, those were the halcyon days for income investing.

More than two decades later, income investors face a much bigger challenge. U.S. stocks have posted mediocre results since 2000, while bonds and cash have provided truly lousy returns after inflation and taxes are taken into account. Stocks pay lower dividends than they used to, especially since top corporate executives now are loaded up with stock options, and those decline in value every time a dividend payout extracts a big slug of cash from the corporate coffers.

The bottom line: While stock prices, interest rates, and inflation are at current levels, and U.S. economic growth remains sluggish, income investors who focus only on domestic income investments will be lucky to break even in cash terms after they have attempted to live on 5% of their capital.

There is a solution, however. In fact, this particular income strategy can offer much better returns than anything a domestic income investor can ever hope to find. We're talking, of course, about investing internationally. Most investors think of the international markets only as another place to seek out stocks. But overseas financial markets are a great option for income investing, as well. And here's why.

The Overseas Option for Income Investors

  • The United States continues to run an annual balance-of-payments deficit of $700 billion. As long as that persists, the dollar will tend to be weak against other currencies. Sometimes, even low-risk investments in the right foreign currency can provide substantial capital gains - and it's not always the obvious currencies. Did you know you could have made more than 30% in dollar terms during the past year from a bank deposit in Czech crowns? And that wasn't some wild investing gambit: These days, the Czech Republic is a perfectly solid middle-income democratic European Union member with an admirable free-market president, Vaclav Klaus.
  • Because U.S. interest rates are so low, many countries have higher interest rates - with lower rates of inflation. Australian, Brazilian, and New Zealand bank deposits all pay more than 5%. All three currencies have recently been strong against the dollar and will likely continue to perform so. And all three of those economies have inflation rates that are comparable to, or lower than, the United States' rate of inflation (South Africa also has 8% deposit rates, but there inflation is too high for safety).
  • While the U.S. economy scuffles along at a 1% pace - and even if it were to recover to 3% - there are a number of countries with growth rates of 5% or greater, not all of which have overvalued stock markets. China and India famously have growth rates of 9%-10%, but what about South Korea and Taiwan?  Both are richer countries with growth rates consistently in the 5%-6% range. By definition, if stocks in those countries are no more expensive than in the United States, they are likely to offer better value.
  • Many stocks outside the United States pay generous dividends, often because they are still controlled by the original founding families who want the income, or because these firms are based in companies with are located in countries with good-value stock markets.

International Income Investing: The Secrets of Success

For income investors seeking dividends from international investments, the secret is to find companies with high dividend yields, but which aren't operating in the kind of risky or highly cyclical business sectors that will make those dividends vulnerable.

In other words, what you don't want to see is a situation where you buy into a stock for its hefty dividend yield - only to have the board of directors of that company suddenly decide that it needs to conserve cash. For instance, Telecomunicacoes de Sao Paulo SA (ADR: TSP), the fixed-line telephone system in Sao Paulo, Brazil, has a dividend yield of no less than 14%. However the company's profit margins are under attack by the aggressive cellphone operators in the country and its earnings seem likely to decline. Indeed, the consensus forecast for TSP's 2008 earnings is about 30% less than the dividend payout, suggesting that dividends will be forced downward - unless the company starts liquidating itself.

Some current recommendations that have good dividend payouts that are also securely covered by earnings:

  • Kookmin Bank (ADR: KB): The largest bank in South Korea, Kookmin has a dividend yield of 4.6% and a Price/Earnings (P/E) ratio of less than 8.0. Kookmin has avoided an entanglement in the U.S. subprime-mortgage mess, but has nevertheless been dragged down by investor disillusionment with the financial services sector.
  • Acer Inc.: Based in Taiwan, Acer is now the world's third-largest manufacturer of PCs, with a global market share that reached 10% since its 2007 purchase of Gateway. Although there are several ways to invest in this company, this is best bought through its Global Depositary Receipts, which are listed on the London stock exchange (ACID). Acer has a dividend yield of 6.4% and a P/E ratio of only 11.0 - pretty alluring numbers for a leader in a major growth sector.
  • Tele Norte Leste Participacoes SA (ADR: TNE): Also known as TNE, Brazil's cellphone compay has a yield of 4.8% and is trading at about seven times earnings.

One final note: Income investing is all too often viewed as a stodgy, no-growth strategy for the total risk-averse. But as Acer and TNE demonstrate, you don't need to confine yourself to stodgy, low-growth sectors to get a juicy dividend yield with good security. You just have to look globally.

[Editor's Note: When it comes to global income issues, Money Morning Contributing Editor Martin Hutchinson knows his stuff.  An investment banker with more than 25 years' experience, Hutchinson has worked on both Wall Street and Fleet Street and is a leading expert on the international financial markets. In February 2000, as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians, who had been stripped of nearly $1 billion by the breakup of Yugoslavia - and then the Kosovo War. Hutchinson's "Insights on Income" column will now be a regular feature in Money Morning].