This is Part 2 of a two-part blog series on the prospects for growth and value stocks. Read Part 1 Growth Stocks: Where’s the Beef?
When your starting point is a 1.4% dividend yield,1 as is the case with the S&P 500 Growth Index, the group of stocks that make up the basket need to have long-term dividend growth that performs like Seabiscuit, the super horse. No tripping out of the gate or getting bumped in the stretch.
Latching on to the concepts in my white paper, Dividend Growth’s Drivers: Picking Apart Quality, we present figure 1, which shows the interrelationship between the percentage of earnings that are retained (as opposed to paid out as dividends) and the return on equity (ROE), which is net income as a percentage of shareholders’ equity.
This relationship is the driver of dividend growth, and as the years go on, concepts like figure 1 have become core tenets of second-decade WisdomTree.
Figure 1: The Critical Equation
Figure 2 uses the critical equation to calculate long-term dividend growth at prevailing profitability levels.
As it stands, the S&P 500 Growth Index’s 23.2% ROE implies long-term dividend growth of 16.8%. That could happen, yes. Anything can happen. But here’s a better idea: expect downward revisions instead.
Figure 2: Implied Dividend Growth Estimate
After all, look at the historic record in figure 3. There isn’t a single five-year period that had growth stocks’ earnings running forward at a 16.8% clip, not even in the roaring 1990s. In contrast, value stocks’ implied dividend growth is on planet Earth.
Figure 3: Dividend Growth Rate, 5-Year Periods, 1995–Present
Does anything jump out in figure 3? Look at the dividend growth experience of growth and value from 2010 to 2015 and from 2015 to the present.
Those growth stocks start to look less like Seabiscuit and more like also-rans if recent years are any indication. Granted, value indexes are dominated by banks, and the period from 2010 to 2018 was characterized by the benefit of their reinstated dividends. Nevertheless, if growth stocks were only able to increase their dividends at a high single-digit rate during this period of irrepressible economic expansion, what happens if recession hits? Let someone else pay 22 times earnings to find out.
Slow and Boring? Better than Growing Out of 1%
The S&P 500 Value Index has a dividend yield that is about double that of the S&P 500 Growth Index (2.7% vs. 1.4%). This kind of gap makes it nearly impossible for the latter index to ever grow out of its valuation.
If U.S. growth could not differentiate its…ahem…dividend growth relative to value from 2010 to 2018, what makes anyone think the next several years will be different? For growth stock skeptics, the WisdomTree Fund that hits value is the WisdomTree U.S. High Dividend Index ETF (HID/HID.B).
It retains 38% of its earnings, pays out the other 62% as dividends and has an ROE of 13.5%. That ROE is satisfactory enough. Using the “critical equation,” it has long-term implied dividend growth of 5.1%, which is less than the levels of the S&P 500 Growth Index. But when the starting point is a 1.4% forward dividend yield, companies that populate indexes like the S&P 500 Growth Index would have to run up their dividends at a 15% or 20% annual pace for a long time before the math even thinks about shifting in their favour.2
For investors who do not want to commit to value because they keep getting burned, a fund like the WisdomTree U.S. Quality Dividend Growth Index ETF (DGR/DGR.B), which tracks the WisdomTree U.S. Quality Dividend Growth Index CAD, seeks to target companies that rank well on our ROE x earnings retention framework.
Critically, its dividend weighting methodology also checks valuations at the door. That gives it a starting dividend yield of 2.7%, about 130 bps more than the S&P 500 Growth Index. It also has an explicit screen for ROE and return on assets (ROA). Its 15.8x forward earnings multiple is 3.3 multiple points below the S&P 500 Growth Index.
Over the next 5 or 10 years, we’ll take DGR.B or HID.B over S&P 500 Growth Index. This is where the rubber meets the road, when the cap-weighted U.S. large-cap growth indexes start to be priced like they’re Seabiscuit, when in reality they’re an underlay.
1Sources: WisdomTree, Bloomberg, as of 11/15/18.
2Sources: WisdomTree, Bloomberg. Unless otherwise stated, all data in this blog as of 11/15/18.
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