Wednesday, November 20, 2013

International Dividend Stocks – Pros and Cons

Investors are always told to diversify. Diversification is the tool to protect investors from the unknown risks at the time of purchase. In my dividend portfolio, I always try to be diversified, meaning that I hold at least 30 - 40  individual securities representative of as many sectors that make sense. For some reason however, my portfolio only has a few companies traded internationally, which account for about 9% of its value.

International exposure is helpful, because different economies run on different market cycles. For example, if the economy in the US is stagnating, Asian countries might benefit from rise in economic output. In addition, some countries might benefit from increase in number of middle class consumers, which could bode well for earnings and stock prices and dividends.

By limiting themselves to only US companies, US investors might miss on international success stories that could benefit returns. With the increase in globalization, it is possible for a company to start small in one country, but then expand internationally. This could lead to increased profits, and hopefully dividends and stock prices. By increasing the pool of companies to look at, investors increase their chances of finding the next dividend gem for their portfolios.

Another positive fact of international dividend investing is diversifying away from the US dollar. By purchasing foreign assets, US investors will be receiving dividends denominated in Swiss francs, UK pounds, Canadian Dollars and others. This could be viewed as a positive by investors who believe that the US dollar will gradually lose purchasing power relative to these currencies over the long term.

While there are certain advantages to holding international dividend stocks, there are also a few disadvantages.

The first disadvantage includes that foreign stocks pay irregular dividends. Most pay distributions only once per year. Others pay dividends twice per year, by paying an interim and a final dividend. Often the interim dividend is 30%-40% of the total annual distribution, with the final dividend accounting for 60% - 70% of the annual distribution. British based telecom giant Vodafone Group (VOD) is a prime example of this. For 2013, the company paid an interim dividend of 3.27 pence/share, while for the final dividend the company paid 6.92 pence/share, or a total of 10.19 pence/share. This is why calculating the dividend yield could be tricky on a company like Vodafone, especially given that the new interim dividend has recently been increased to 3.53 pence/share.

Other companies like global food giant Nestle (NSRGY) pay dividends once per year, and withhold 15% for US residents. Check my analysis of Nestle.

Another disadvantage of foreign dividend stocks is the fact that few international companies follow a managed dividend policy like US companies. Most US corporations pay a stable and rising dividend, and avoid cutting distributions at all costs. Most foreign companies tend to pay a fluctuating dividend, which could vary greatly from year to year. This variability is caused by the fact that most foreign companies tend to target a certain dividend payout ratio. Since earnings per share fluctuate, so do dividend payments to shareholders of these non-US based companies. Investors also need to be careful in following dividend trends in the local currency, rather than the US dollar converted amounts. For example, for Unliever, it seems like distributions are declared in Euros, and then translated into pounds for PLC holders and dollars for ADR's traded on US markets. Therefore, anyone who followed the dividend trends in pounds or dollars, would be focusing on noise. Focus on the dividend trends in Euro's for Unilever.

Another disadvantage of owning foreign dividend stocks includes steep withholding taxes on distributions. These are typically withheld at source and could vary country by country. These taxes on dividend incomes charged to US investors could vary from 15% to as much as 25%. Investors can usually deduct taxes withheld fully if they are within 15%, using IRS form 1116. US investors who receive foreign dividends in retirement accounts however are still taxed on distributions receive, and cannot get them back. UK is one of the few countries which does not withhold taxes on dividend income paid to US investors. There are several companies which are headquartered in the UK and in another country such as the Netherlands or Australia. As a result, whenever you have a choice between the UK and the other country shares, always select the UK listed one.

Unilever is a prime example of this situation. There are two ADRs trading on NYSE. The Netherland based Unilever N.V. trades under ticker (UN). The UK based Unilever PLC trades under ticker (UL). Investors in both stocks get exactly the same dividends. The only difference is that investors in Unilever NV (UN) are subject to a 15% withholding tax, whereas investors in Unilever PLC (UL) are not. US investors still need to pay taxes on international dividends received however, if paid in taxable accounts.

In addition, some countries do not levy withholding taxes on dividends that are received in retirement accounts, such as Roth IRA's for example. The prime example includes Canada, which usually withholds 15% from dividends paid to US residents at source. However, if you placed those securities in retirement account, Canada would not tax these dividends.

Investors in international equities also need to be aware of the fact that these companies are likely not following US GAAP accounting rules. The whole world seems to have adopted IFRS, albeit it doesn’t seem to have a very consistent implementation. It seems as if each country has managed to implement its own version of IFRS. In addition, investors purchasing foreign shares on international exchanges might find it difficult to open brokerage accounts, wire funds in and out and need to be aware of taxation of dividends and capital gains. For example, Chinese markets are mostly closed to US investors. This means that you cannot go and purchase any Chinese stock that you wish. Other countries have currency controls in place, and might limit the amount of funds you can convert back to US dollars.

In conclusion, while there might be some benefit to receiving international dividends, there are also a lot of cons that investors need to be aware of. In general, I try to purchase US multinationals with long histories of dividend increases, which also have global operations. I have found that a large portion of US dividend companies revenues are derived from international operations, in some cases more than 50%. As a result, I do not have to deal with currency volatility, foreign withholding tax rates, setting up brokerage accounts in 20 different countries and international accounting rules.

For example, when I looked at the ten largest components of the S&P 500 index, I found out that they generate approximately 50% of their revenues from outside the US in 2012. This is significant, and it should probably make you think twice before using measures such as comparing current market capitalization to US GDP to past values of this indicator, as a tool that has any relevant predictive value.

Full Disclosure: Long UL, VOD, NSRGY, XOM, JNJ, CVX, PG, WFC

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