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Case for International Quality

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For decades, dividend income has been a crucial component of a stock investor’s total return, often surpassing capital appreciation in volatile markets for many investors. Dividends are also valued in an interest rate environment of falling yields on bonds and rates at or near zero when income-seeking investors typically widen their search for yield to meet their retirement and spending goals.

Blindly focusing on yield in the international sector, however, could be dangerous to an investment portfolio’s health. Often, a seemingly generous dividend yield may actually signify a weak share price tied to negative news not yet revealed in the quarterly dividend. This explains why we believe investors in international dividend stocks must be confident that the dividend being paid is sustainable over the long term, meaning that the payout is well covered and the payer company has the potential to grow it over time.1

The world can potentially be productive terrain for finding quality dividend yields.

ACROSS THE GLOBE, MOMENTUM BUILDS

According to the International Monetary Fund (IMF), "global economic activity continued to firm up with global output estimated to have grown by 3.7 percent in 2017."2 They further predict that global growth forecasts for 2018 and 2019 have been revised upward by 0.2 percentage point to 3.9 percent.3

historical and projected GDP growth

Nowhere, however, in our opinion is that more apparent than in the U.S. which has been driven by continued consumer spending and recently enacted tax reform. This has propelled market capitalizations to ever-higher levels for U.S. equities with U.S. stocks nearing the top of their historical range.4

Market Capitalization as a % of MSCI ACWI

AND THE SEARCH FOR YIELD GOES ON

According to the U.S. Census bureau, there are nearly 50 million people over age 65 in the U.S. with more reaching this age every year. For many of them who are retiring baby boomers, the search for dividends as they move into the next phase of their lives is forcing them to search far and wide. We believe that dividends have always played a significant role in driving equity returns and helping investors meet their financial goals. Dividend income may be especially important during those retirement years.

In the U.S., we believe that this increasing demand for dividend income has in part driven valuations for many traditional dividend payers high above their long-term averages. For investors willing to look for these dividends outside the U.S., there are a significant number of companies in both developed and emerging international markets with historically high dividend yields.5

Stocks with yields of 3% and higher as of December 31, 2016

So, how can investors judge an “endurable” yield? We believe there is a better approach. One that involves focusing on the core financial health of the underlying dividend-paying company.

HISTORICAL DIVIDEND STRATEGIES MAY CLOUD INVESTOR JUDGEMENT

Through the years, several strategies have been widely applied to avoid overpaying for dividend-driven yield. First, longevity. If a company has paid a dividend for a long time, investors trust it is likely to continue paying a future dividend. The alternative, focusing on dividend growth over time, views a reduction in the distribution as a red flag the dividend may either not be paid in the future or may actually be pared back further.

Both approaches are flawed in that they:

  • React to a reduced dividend only after it happens, resulting in holding the dividend-paying security until the next rebalance, well after the market reflects the negative dividend news into the stock price
  • Require a long history of dividend payouts (often a decade or two) in order to properly evaluate a company, which means newer dividend payers are excluded from consideration
  • Tend to downplay recent changes in the macro environment that may drastically affect the company's ability to maintain or grow its dividend

Further, a singular focus on payout ratios, which is the proportion of earnings paid out as dividends to shareholders and typically expressed as a percentage, may eliminate companies in mature industries that return most of their income to shareholders but are financially stable and well positioned to maintain that dividend rate.

IMPORTANCE OF CORE FINANCIAL HEALTH

Measuring a company’s core financial health makes it possible to evaluate the likelihood that it will increase (or need to decrease) its future dividends. With this approach, the reliance on publicly available financial data means new dividend payers can be evaluated similarly to stocks that have paid dividends for decades. By using several lenses to evaluate the actual financial health of the organization, the FlexShares’ Dividend Quality Score (DQS) is designed to provide insight into how well positioned a dividend-paying company is for success, and how protected future dividends are under current market/economic environments.

DQS examines companies using 3 lenses for its Dividend Quality Index methodology

For international dividend payers, the DQS score evaluates dividend-paying equities across all of these lenses, ranks companies on a sector basis and evaluates firms on both a regional and sector basis. This not only ensures an “apples-to-apples” comparison – profiling like firms against each other – it also serves to identify quality companies in every sector and country, supporting diversification through the construction process and opportunity set.

MAXIMIZING QUALITY AND YIELD

Quality and yield have not been highly correlated historically, but the combination looks to produce compelling results as it serves to smooth each respective factor’s cycle.

FlexShare’s International DQS process is designed to maximize quality and yield while putting several diversification controls into effect for large cap securities. The strategy strives to harness dividend quality and yield through its selection and weighting process. Non-dividend payers are eliminated from the universe of large cap equities, as are the lowest 20 percent of companies in the DQS ranking. Additionally, the strategy seeks to limit non-targeted factors by placing relative sector, security, style and market volatility (beta) bounds based on the parent universe.

Some investors prefer a beta target less than or greater than the parent index, so FlexShares offers “defensive” (beta less than the parent) and “dynamic” (beta greater than the parent) index options. The FlexShares International Quality Dividend Suite includes three funds.

Tickers and Fund Names

FIND OUT MORE

The FlexShares approach to index-based investing is, first and foremost, investor-centric and goal oriented. We pride ourselves on our commitment to developing products that are designed to meet real-world objectives for both institutional and individual investors. If you would like to discuss the attributes of any of the ETFs discussed in this report in greater depth or find out more about the index methodology behind them please don’t hesitate to call us at 1-855-FlexETF (1-855-353-9383).


END NOTES

1 Dividends represent past performance and there is no guarantee they will continue to be paid.
2 International Monetary Fund. World Economic Outlook 2018. 22January2018. Retrieved 12Feb2018 from https://www.imf. org/en/Publications/WEO/Issues/2018/01/11/world-economic-outlook-update-january-2018.
3 Ibid.
4 MSCI All Country World Index, as of 12/31/2017.
5 Bloomberg, MSCI U.S. Equities IMI Index (United States), MSCI Emerging Market Equities Index (Emerging Markets) & MSCI World ex-U.S. IMI Index (International) as of 12/31/17.
6 Ibid.


IMPORTANT INFORMATION

FlexShares International Quality Dividend Index Fund (IQDF), FlexShares International Quality Dividend Defensive Index Fund (IQDE) and the FlexShares International Quality Dividend Dynamic Index Fund (IQDY) are passively managed and use a representative sampling strategy to track their underlying index. Use of a representative sampling strategy creates tracking risk where the Fund’s performance could vary substantially from the performance of the underlying index. Additionally, the Funds are at increased dividend risk, as the issuers of the underlying stock might not declare a dividend, or the dividend rate may not remain at current levels. The Funds are also at increased risk of industry concentration, where it may be more than 25% invested in the assets of a single industry. The Funds may be more susceptible to adverse economic, market, political or regulatory occurrences affecting that country, market, industry, sector or asset class. Finally, the Funds may also be subject to increased volatility risk, where volatility may not equal the target of the underlying index.