One clear sign that sets good stocks apart from the restDividends are a fundamental source of returns for investors. Looking at an investment in the S&P 500 since 1930, 41% of the performance generated would have come from dividends1. This is almost half of the total returns. Having said that, there are many ways to invest in dividend-paying stocks: from focusing on companies with high past dividend yields, to companies with the capacity to grow their dividend in the future. At WisdomTree, we believe that high-quality, dividend-growing companies can offer investors a great long-term risk-return profile.
The historical outperformance of dividend growers
Dividends have generated a large portion of the returns for the market at large. Looking at a company level, the dividend policy is also a good indicator of performance. As illustrated in Figure 1, dividend-paying companies have outperformed non-dividend-paying companies by more than 5% annualised since the 1970s. Very interestingly, even inside dividend-paying companies, we can observe a difference between companies depending on the trajectory of their dividends. Companies that cut their dividend tend to post the worst performance. While companies that increase their dividend over time tend to do the best.
The defensiveness of high-quality dividend payers
Dividend paying companies and dividend growing companies also exhibit a very interesting risk profile. To assess their defensiveness, we look at the performance of different types of equities in different market regimes, as defined by the level of volatility during the month. To do so, in Figure 2, we split all the months since 2002 into five buckets from the less volatile months in the lowest quintile to the most volatile months in the highest quintile. It is clear that high-dividend stocks and, even more so, high-quality dividend growing stocks generate, on average, much outperformance during the most volatile months (the highest quintile). In other words, in volatile months, which also tend to be bad for equities, dividend-growing stocks outperform and defend investors' portfolios. It is worth noting that, as the volatility lowers, the outperformance of high-dividend stocks tends to lower, turning to underperformance. This is not the case for high-quality dividend growing companies that, in fact, continue to outperform, or at least match, the market.
Overall, high-quality dividend growers are defensive and tend to outperform in highly uncertain, highly volatile markets, but they are also able to deliver outperformance and capture the upside in less negative markets.
Where to find dividend growing companies
Dividend growing companies can deliver long-term outperformance while protecting investment on the downside. But how can investors find those dividend growing companies? By definition, investors will know if a company is increasing its dividend only after the fact, once the dividend has been grown.
Many investment strategies look back at past dividend payments to assess a company's potential for dividend growth. While this approach is intuitive, it is not very reactive; a company would be dubbed a dividend-growing company only when it has been one for multiple years. It is also risky as it does not consider what could change going forward. However, it is possible to have a more forward-looking view, focusing not on past dividend payers but more on future dividend payers through the formula below.
Retention Ratio x ROE = Implied Dividend Growth
Suppose a company earns $1 per share and pays a 25-cent dividend, leaving 75 cents in retained earnings. The retention ratio is 75%. Multiplying the retention ratio by the return on equity (ROE) would give you the amount of money left for future dividend payments, that is, the implied dividend growth. In other words, the implied dividend growth for a company is directly linked to the current profitability of the company. By focusing on highly profitable companies, it is possible to improve the potential for future dividend growth.
Overall, by focusing on highly profitable, earnings-growing companies, such strategies are geared towards companies with the potential to outperform over the long term, reduce risk and grow their dividend more over the next few years.
Sources
1 Source: Ned Davis Research Inc. 1 January 1930 to 31 December 2022.
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
