The End of Dividend Growth Investing? Not So Fast . . .
One concern being raised among dividend growth investors is the idea that the ‘Golden Age of Dividend Growth’ has reached its peak. One such article, published earlier this year by Morningstar DividendInvestor editor Josh Peters, argues that as rising dividends and falling company profits lead to what he considers a historically normal payout ratio for the S&P 500, and that dividend growth will be constrained. He cites the S&P 500 dividend per share growth of only 4.6% in 1Q 2016, the smallest growth in the last few years, as evidence of this idea that dividend growth has already slowed. This concept seems especially troubling to many, as many asset classes currently either offer very low yields or are considered expensive.
After examining the relationship between dividend payout ratios and earnings of the S&P over time, Peters concluded that dividend growth may be nearing its peak. Over the past 10 years, dividends have doubled (from $219 billion to $420 billion), where earnings or total net income only grew from $712 billion to $874.8 billion1. It’s important to note that dividends are paid out of free cash flow, and the robust increase in free cash indicates further capacity for future dividend growth. In addition, companies have become healthier in the past few years. Though Peters is correct that over the course of the last 10 years, dividends as a percentage of earnings started showing some troubling signs, dividends as a percentage of free cash flow, and cash & equivalents have actually decreased, leaving room for further potential growth2.
Peters notes how the increase in dividend payout ratios has not been accompanied by an improvement in dividend yield as yet. He also writes that dividend yield will not rise. Though it might be true that payout ratios are historically normal, this does not necessitate the end of dividend growth in the S&P 500. Additionally, Peters fails to mention how much increasing stock prices contribute to stagnated dividend yields and conversely, how yields would of course spike up if prices drop. While we agree that dividend yield can be an important factor to consider, when building our proprietary dividend health rating system, we found dividend growth to be a more important consideration on future performance.
Reality Shares developed the DIVCON dividend health rating system to better determine whether dividends are likely to continue growing. DIVCON analyzes companies according to seven factors – free cash flows, earnings per share growth, dividends per share, buybacks and repurchases, DPS growth forecasts, and Bloomberg and ALTMAN Z-score ratings – and weights, scores and categorizes each company based on the results. The healthiest companies earn the highest DIVCON scores and a rating of DIVCON 5, indicating a very strong likelihood they will increase their dividends in the next 12 months. The least financially stable companies as determined by the analysis are given the lowest DIVCON scores and are rated DIVCON 1, or very risky, indicating a likelihood they could cut their dividends in the near future.
In our analysis of the dividend paying companies in the S&P 500, we discovered that dividend paying companies have generally become healthier over the past 15 years, not less healthy. The number of companies categorized as DIVCON 1 or 2 have decreased. This is true even as the number of dividend paying companies increased from 357 to 418 from 2000 to 20162. Correspondingly, the number of DIVCON 4 and 5-rated stocks have increased in the same timeframe, indicating that overall company financial health has notably improved.
Jan. 2, 2002, through Jun. 30, 2016. Source: Bloomberg, S&P Capital IQ, Reality Shares Research. Past performance does not guarantee future results.
Reality Shares then compared these very same stocks to their historical dividend payout ratios, looking to determine if there was any correlation between the two factors. Generally speaking, dividend payout ratios have increased over the years, indicating the Morningstar article was correct on this point. On average, payout ratios have been much higher for DIVCON 1 and 2 stocks – the companies rated as the lowest quality and the most likely to cut their dividends in the future (based on DIVCON). This makes sense, as these companies are generally paying higher dividends than they should be considering their financial state. Payout ratios have always been high among DIVCON 1 and DIVCON 2 stocks and have increased over the years. Among DIVCON 4 and DIVCON 5 stocks, payout ratios have also increased, but they have not impacted dividend growth. Furthermore, when comparing the average dividend growth among DIVCON 1 and DIVCON 5 stocks and looking at the difference in quality and payout among those stocks, the market shows the potential to grow its dividends. Within the S&P 500 itself, there are few companies actually exhibiting a high payout ratio.
The Highest Quality Stocks Measured by DIVCON Have More Room to Grow Dividends
As of Aug. 31, 2016. Source: Reality Shares Research. Past performance does not guarantee future results.
DIVCON stocks categorized with the lowest payout ratios, DIVCON 4 and DIVCON 5, carry a high likelihood and potential for growing their dividends. So, it could be argued that the golden age of dividend growth investing is over for financially unhealthy companies falling in lower tiers of dividend quality where payout ratios are indeed high. Yet, opportunity still exists for dividend growth investing in healthy firms, those DIVCON 4 and DIVCON 5-rated companies, where company fundamentals and the ability to pay dividends are much better.
Some of the data points Peters highlighted, such as the low growth of the S&P 500 dividends in 1Q 2016 of only 4.6%, have already shown a turnaround in 2Q 2016 to 5.5%, and are still exhibiting healthy growth. There are record levels of cash on corporate balance sheets, and some of the largest market cap companies in the S&P 500 have yet to pay a dividend. Companies like Apple have the cash resources to pay much more in the way of dividends relative to current payout levels. Dividend growth will likely be further driven upward by current non-payers holding substantial cash balances. We believe companies like Facebook and Alphabet are likely to initiate payouts in the future, potentially impacting overall S&P 500 dividend growth significantly. The Financials sector, which was once the dividend leader until the Great Recession, is in recovery and has already surpassed Information Technology in aggregate dividend payouts. Companies within the sector are growing dividends following multiple rounds of positive Fed stress tests. In addition, some of the negative dividend sentiment is focused in traditionally higher yielding sectors such as Energy, Utilities and Telecom. These segments do not currently rank favorably for future dividend growth prospects. It’s important to note, high yield does not necessarily mean high quality when it comes to dividend investing.
So what does all of this mean? We do see some validity in the caution discussed with higher-yielding dividend payers, but high-quality names that have the potential to continue to grow their dividends remain a potentially strong spot in this environment. S&P forecasts call for 2016 to be another record year for S&P 500 dividends3. Our own research indicates dividend payouts will continue to grow this year, and select stocks may benefit. Annual S&P 500 dividend growth has been negative just three times in the past 50 years2, across a wide variety of earnings and interest rate environments. Companies tend to cut dividends as a last resort, and we believe the recent earnings slump will not warrant any extreme dividend measures. Furthermore, publicly-traded companies are now in the purview of activist investors, who can influence corporate action on behalf of investors. Activist investors often demand dividend increases to return capital and reward shareholders and push for shareholder buybacks on the table to protect investors. They also pose a potential blockade to dividend cuts. As earnings growth is uncertain and cyclical, dividend income is often a more reliable driver of returns, providing a quality equity option in today’s slower-growth environment.
Reality Shares offers a range of ETFs that participate in dividend growth. Financial advisors can download our recent white paper or call (855) 595-0240 to find out more about the Reality of Dividend Growth.
1 As of August 31, 2016
2 Source: Reality Shares Research
3 Source: Standard & Poor’s Dividend Memo, October 5, 2016
S&P 500: A broad stock market index of 500 large companies based on market capitalization. You cannot invest directly in an index. Dividend Yield: A ratio that indicates how much a company pays out in dividends each year relative to its share price. DPS Growth Forecast: Analyst consensus forecast for the dividend growth of a specific company. Bloomberg Dividend Health Score: A proprietary dividend health scoring system developed by Bloomberg, on a scale of 0 to 100. Altman Z-Score: Credit-strength test that gauges a company’s likelihood of bankruptcy.