In today’s market, dividend investing is the best way to achieve a decent income stream without taking on too much risk.

On the other hand, this is also true: emerging markets give investors the benefit of the world’s fastest economic growth.

Investors would be wise then to combine these two strategies by buying emerging markets stocks that pay steady dividends.

[ad#Google Adsense 336×280-IA]In practice, this is more difficult than it ought to be – but it’s not impossible.

In fact, as you’ll learn later I have found numerous ways to profit from this best of both worlds strategy.

What You Need to Know About Emerging Market Dividend Stocks

Dividend-paying stocks in emerging markets have the same advantages as they do in the U.S. market.

Just like here in The States, a sizeable dividend from overseas is not only money in your pocket, it’s also evidence that the management is working in your interests as a shareholder.

And by paying dividends investors can be sure that at least some of the earnings the company is generating are real and not the result of an accounting flim-flam.

If a company in a fast-growing emerging market is able to pay a decent dividend and participate in local growth, then you can anticipate very good returns indeed, since the dividend itself is likely to grow on the back of the company’s rapidly increasing profits.

Of course, there are always risks in emerging market investing, but a good yield gives your holding a solidity that isn’t present in companies with mere paper earnings.

But here’s what you need to know…

If you’re investing in foreign dividend-paying companies directly, you should do so in a taxable account.

Most countries impose a withholding tax of 20% or so on the dividends paid to U.S. recipients before you receive them.

In a taxable account, these foreign withholding taxes often (but not always) give you a credit against your payable U.S. taxes.

In a tax-free retirement account, which is the most sensible place for most investments, there is no U.S. tax against which the withholding tax can be offset, and so the yield to you is correspondingly reduced.

How to Choose the Right Emerging Market Dividend Stocks

Another problem with investing in emerging market dividend payers is that many of them, particularly those located in countries where bank finance is expensive, prefer to retain earnings and thereby reduce bank debt rather than pay dividends.

The Brazilian Petrobras (NYSE: PBR), for example, pays out only 5% of its earnings in dividends, giving investors a yield of only 0.5%.

Another example is America Movil (NYSE: AMX).

The Mexican mobile telecom company is the basis for Carlos Slim’s world-leading fortune. America Movil pays out only one sixth of its earnings and yields just 1.1%.

Conversely, in Taiwan, companies gain tax benefits by paying out 80% of their earnings in dividends.

As a result, some Taiwanese companies have high dividend yields, although the really juicy ones tend to occur when the semiconductor cycle is favorable, which it currently is not.

Still, even at a mere 2.9% yield, Taiwan Semiconductor (NYSE: TSM) is worth considering.

Two Ways to Create an Emerging Market Income Stream

Since many of the better paying companies are not listed on U.S. exchanges, the most efficient way to buy emerging market dividend stocks is through a fund.

The largest and most solid of these is the WisdomTree Emerging Markets High Yielding Equity ETF (NYSE: DEM).

This fund has total assets of a chunky $2.7 billion and an expense ratio of 0.63%. It also has an attractive yield of 4.12%, which is highly competitive with even the longest-term Treasury or agency bonds. The fund’s P/E ratio is a modest 11 times earnings.

The fund has 280 holdings with a good range of emerging market exposure – 21% in Brazil, 20% in Taiwan, 9% in South Africa, 8% in Malaysia, and 5% in Chile.

In terms of sector exposure, finance represents 27% of the fund. But not to worry — this is less of a problem in emerging markets, where the follies of Western banking are only mildly apparent!

Other industries include telecoms at 20% of the fund, IT at 13%, and materials and utilities each at 10%.

Alternatively, if you’re feeling adventurous and looking for high-yielding exotica, try Kumba Iron Ore (PINK: KUMBF).

It’s one of the largest companies you’ve never heard of.

Kumba has a market capitalization of $23 billion, and is the iron ore mining subsidiary of Anglo American, the well-known South African mining group.

The company just reported a 19% jump in 2011 earnings. Yet the stock is trading at only 10.6 times trailing earnings, with earnings per share (EPS) expected by analysts to increase another 10% in 2012.

It has declared a final dividend of 22.50 South African Rand ($2.91 at today’s exchange rate), which is expected to go ex-dividend in March. And in August 2011 it paid an interim dividend, for a total of ZAR44.20 ($5.72 approximately), a yield of 7.6% currently.

With iron ore prices strong on continued Chinese growth, KUMBF looks like an interesting buy, and is not overpriced.

Either way, income investors would be wise to look into emerging market dividend stocks.

They really are the best of both worlds.

— Martin

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Source: Money Morning