Yearly periods ending with a high trailing dividend yield have performed well on an average in the following year. With the trailing 12-month dividend yield as of 31 January 2013 at 2.69%, 44 basis points above the median, emerging market equities look attractively poised

Investing in high dividend yield stocks is a traditional way to make money on the stock market. This valuation metric is widely used by investors. According to a recent research report titled—Why We Are Still Bullish On Emerging Market Equities For 2013—by a US-based fund house WisdomTree Investments, emerging market companies are, by and large, mostly dividend payers. The trailing 12-month dividend yield has been an important valuation indicator for the subsequent performance of the MSCI Emerging Markets Index. The present levels of dividend yield for emerging markets have been associated with a strong positive performance in the past. 

Based on the last 24 full calendar years of data on the MSCI Emerging Markets Index, in the years following a higher trailing 12-month dividend yields (having a yield higher than the median observation of 2.25%), the MSCI Emerging Markets Index generated returns that averaged 33.03%, more than 31 full percentage points above the return following low dividend yield years. The average return for all 24 calendar years was 17.47%.
 

The research further points out that four of the five best yearly return periods for the MSCI Emerging Markets Index were followed by trailing 12-month dividend yields that ranked among the five highest of all 24 calendar year returns. The dividend yield was the highest for the year-end of 2008 at 4.75%. The year following this delivered the highest 12-month forward return of 79.02%. Is the reverse true as well? Yes. The lowest dividend yield for the index was observed for the year-ending of 1999 and was followed by the second-worst yearly returns of -30.61%.

Doing our own research on the BSE Sensex for the yearly periods from 31 December 1994 to 31 December 2012, the highest 12-month trailing dividend yield was at the end of the year 2002 with a yield of 2.14%. The year following that delivered the second highest return of 72.89%. The lowest dividend yield was on 31 December 2007 at 0.83% and the following 12-month period delivered the lowest return of -52.45%. The average yield has been 1.51% and as on 28 March 2013 the dividend yield was 1.61%. The level of dividend yield though slightly higher, may not be too attractive for investors.

“Emerging market companies are, by and large, mostly dividend payers. Well over 90% of the weight of the MSCI Emerging Markets Index is in firms that have paid a dividend in the preceding 12 months”, mentions the report. Higher trailing 12-month dividend yields indicate that a greater amount of aggregate dividends has been generated over the past 12 months relative to the current share price, while lower trailing 12-month dividend yields indicate the opposite. As per the report, “During periods that ranked as expensive for emerging markets, the average return was just 1.90%. This dramatic difference is a significant signal for the best time to own these equities. This historical analysis is why we would say we are still bullish on emerging market equities for 2013.”

Valuations have been a good guide to the future relative performance of various sectors. The research cites a study by Jonathan Garner and his team at Morgan Stanley, for the period from 31 December 1995 to 31 January 2013, “defensive stocks” within the MSCI Emerging Markets Index universe have tended to trade at a price-to-earnings (P/E) ratio approximately 1.3x that of “cyclical stocks” from the same universe. This is also of little surprise when one realizes another important statistic cited in this Morgan Stanley research: during 2012, defensive stocks outperformed cyclical stocks by 966 basis points.

The WisdomTree research reasons that investors may be willing to pay a higher price to gain exposure to more defensive stocks within this space. From 2011, emerging market defensive stocks have been trading at a more significant premium multiple relative to cyclical stocks. Therefore according to the research defensive stocks are currently “too expensive.” This has happened before, but there has been a tendency for the relationship to go back toward 1.3x. Morgan Stanley shows that when defensive stocks have traded at such expensive multiples compared to cyclical stocks in the past, their forward-looking relative performance has suffered.