Wednesday, October 23, 2013

Driving the Bull: Dividend Growth Pushing the Market Higher

Now that the government shutdown is past us and the debt ceiling has been pushed out for the near term, we thought it would be an interesting exercise to share with our readers some recent research that we have done in attempting to identify which types of stocks are doing the best in the current bull market.  

S&P 500 Total Return Analysis

The stock market has had a strong run since 2009.  Over the last 12 months, the S&P 500 is up approximately 25%.  We broke the S&P 500 companies down into quintiles of 100 stocks each and ordered them according to largest to smallest in 4 different fundamental categories including sales growth, earnings growth, dividend yield and dividend growth.  We then calculated the total return (dividends and capital appreciation) for each quintile over the last 12 months.

The 12-month total return of the top 100 sales growers was 22.2%.  The top 100 earnings growers had a nice return of 26%.  The 100 highest dividend yielding companies only grew 13.7%.  How did the top 100 dividend growers fare over the past 12 months?   A staggering 35.9% total return. 

The market is placing a significant premium on dividend growth over sales growth, earnings growth and higher dividend yields.  With interest rates continuing to stay low, dividend growth companies will continue to be valued at a premium to their peers.

A Closer Look

Taking a closer look at the data reveals some interesting findings.

The most obvious conclusion that you can make is that the best performers in every single category except dividend growth were not rewarded with the best total return.  In fact, some of the worst performers in each category had better total returns than the top performers by a wide margin.  For instance, the 100 companies with the lowest earnings growth outperformed the 100 fastest earnings growers by nearly 8%.

The dividend growth rates predicted total return the way we would expect, with the top dividend growers leading in total return with each subsequent quartile lagging the top 100.  The exception was the 5th quintile, which performed just as well as the growth leaders.  This seems peculiar until you consider who makes up this quintile.  Keep in mind that only 415 companies in the S&P 500 pay a dividend, so the majority of the companies in the lowest dividend growth quintile do not pay a dividend at all.  The companies in the S&P 500 that do not pay a dividend tend to be primarily in two industries – technology and healthcare.  These companies are generally smaller and faster growing than the other companies in the Index. 

The clear distinction between dividend growth quintiles indicate that small, fast growing companies are doing very well.  This is further evidenced by the substantial performance margin between the small and mid cap indices relative to the S&P 500 in 2013.  In a future blog post, we will discuss the performance of the small and mid-cap companies in more detail.

Bullish Trends
In stepping back to look at the entire table, we see a couple of major trends.

First of all, there is no doubt we are in a bull market.  As our research shows, no fundamentals – aside from dividend growth – indicate much correlation with total return.  All stocks have been moving higher.  The question so many investors have is: How can the market be doing so well despite so many headwinds (political stalemate, Fed tapering, worries in Europe) and only 4.5% earnings growth?  We will discuss this more broadly in another blog post, but the simple answer is – we have been facing many headwinds that have impeded growth, but there are two major tailwinds that are winning the day:
  1. “Don’t Fight the Fed”.  
    The Fed’s accommodative stance towards monetary policy has had the final say over many of the worries we have faced.
      The market’s reaction to the Fed’s May taper talks speaks to the power of their stimulative policy.  Many of our experts now believe tapering is off the table until early 2014.  That is very good news for the stock market.
  2. Dividend Growth Outpacing Earnings Growth
    Dividends growth has been more than 3x earnings growth over the past 12 months.
     The financial media doesn’t talk much about it, but this is one of the strongest indicators of confidence in corporate America.  Dividends represent real cash paid out.  If companies were worried about the future, they would hoard cash to face whatever crisis is coming next.  They have been doing the exact opposite – increasing their dividends by nearly 18%.  Companies are much more bullish about the future than the headlines seem to indicate.  As we talked about last week, we anticipate this will continue as dividend payout ratios return to more historic levels.
We strongly believe dividends have just as much to say about the future as they do about the past.  If that is the case and companies are correct in their optimism, the stock market’s future is still very bullish.