By Jeremy Schwartz, Christopher Gannatti and Tripp Zimmerman
WisdomTree conducts the annual rebalance of its U.S. Dividend Index family in December, with the annual screening date occurring on the last trading day of every November. The annual screening date is when each qualifying company's indicated dividends per share are measured, whereas the actual rebalancing transactions that adjust the Index to these new weights occur in December. This rebalance provides a plethora of data about how dividends for the U.S. equity markets have changed over time. In this year's rebalance analysis, we focus on the following areas:
- Part 1: The Drivers of Our Relative Value Rebalance and Valuation Discussion
- Part 2: Key Features of Aggregate Dividend Stream® Growth in 2013 by Sector
- Part 3: Dividend-Paying Trends by Market Cap
- Part 4: The 20 Largest Dividend Payers in the United States
- Part 5: Analysis of Sector Shifts in Select WisdomTree Dividend Indexes
PART 1: THE DRIVERS OF OUR RELATIVE VALUE REBALANCE AND VALUATION DISCUSSION
With market capitalization-weighted indexes, when constituents increase in price compared to other stocks, they gain greater weight and impact on the performance of the index. WisdomTree Indexes employ a rules-based rebalancing mechanism that adjusts relative weights based on underlying dividend trends. During the rebalancing process, which occurs once per year for each Index, the relationship between price change and dividend growth is measured.
Dividend growth is a key factor in determining which companies get increased weight at each rebalance. In the table below we quantify the dividend growth for companies that received increases or decreases in weight and compared that to the overall universe.
For the broad Index of dividend payers, the WisdomTree Dividend Index:
+ The companies that saw their weight increased at the rebalance had a median6 dividend growth of 17.0%, which was greater than the median dividend growth of all companies (8.4%). Companies that saw their weight lowered at the rebalance had below-average dividend growth of just 5.1%.
+ Moreover, price performance was also a key driver of relative changes. The stocks that saw their weight increased at the rebalance had below-average returns. The typical stock that saw its weight increased had a median total return that was over 15 percentage points lower than the median of all stocks. The typical stock that saw its weight decreased had a median total return that was 9 percentage points higher than the median of all stocks.
From this data across Indexes, one can generalize the impact of the rebalance as follows:
+ WisdomTree's Dividend Index rebalance process typically is driven by both:
- Dividend growth: Faster dividend growers see weight increased
- Relative performance: Underperformers typically see weight increased; outperformers often see weight decreased
During periods of strong short-term performance such as we saw in 2013, it is especially important to ask whether these moves are justified by the underlying fundamentals. We think it is important to be mindful of the ways an annual rebalance back to an underlying fundamental-such as dividends-can help manage valuation risks. Below we show the valuations across the Dividend Index family.
+ WisdomTree Indexes Typically Exhibit Lower Valuations: Whether one is looking at the price-to-earnings ratio or trailing dividend yields, WisdomTree Indexes will typically exhibit lower valuations compared to their market cap-weighted benchmarks. The annual rebalancing process helps manage valuation risk by consistently shifting weight toward firms that have exhibited greater rates of dividend growth than others. It is in this way that WisdomTree looks to mitigate the risk of being exposed to firms that may have enjoyed strong momentum and price increases but whose valuations have not improved commensurately.
+ Forgotten Dividend Payers: Small and Mid-Caps: When investors think of dividends, they tend to think of mature large-cap companies as the primary source. This thinking might appear correct when looking solely at market capitalization-weighted indexes, but this does not necessarily have to be the case. WisdomTree's Dividend Index methodology is notably different than a market capitalization-weighted approach, and as a result the WisdomTree SmallCap and MidCap Dividend Indexes had higher dividend yields than the S&P 500 Index.
+ High-Quality Dividend Growth: The future growth expectations of the WisdomTree Dividend Growth Indexes are the highest among the WisdomTree Indexes displayed above, and better or comparable to their market cap-weighted benchmarks, especially considering that all constituents in the WisdomTree Indexes are dividend payers. The Dividend Growth Indexes also displayed the highest quality factors, illustrated by high return on equity and return on asset levels. We believe the combined ranking of earnings growth and quality factors is a key element of our process of identifying stocks with the highest potential to increase dividends.
PART 2: KEY FEATURES OF AGGREGATE DIVIDEND STREAM GROWTH IN 2013 BY SECTOR
+ New Record Dividend Stream: 2013 marks the fourth consecutive year of double-digit growth for the U.S. dividend stream. Remarkably, the cumulative decline of more than 23% from 2007 to 2009 has been erased, and 2013 marks a new record high-27% above the mark set 2007.
+ Ex-Financials vs. Financials: As of November 30, 2013, the U.S. dividend stream for the nine sectors excluding Financials is 56% higher than the level seen on November 30, 2007. Financials, on the other hand, are still nearly 32% below their November 30, 2007, levels.
+ Tech Titan Growth: Information Technology sector dividends have grown a remarkable 221% since November 30, 2007. At the prior peak, this sector comprised only 5.6% of the dividend stream, whereas now it comprises more than 14% and is the second-largest dividend-paying sector behind Financials.
+ More Diversified Dividend Stream: On November 30, 2007, approximately one-third of the U.S. dividend stream came from the Financials sector. As of the new November 30, 2013, peak, the Financials sector comprised only about 17.8% of the U.S. dividend stream. No single sector is above a 20% weight.
PART 3: DIVIDEND-PAYING TRENDS BY MARKET CAP
The November 30, 2013, rebalance screening makes it clear that the dividend stream has grown significantly, and one reason for that growth is the increased number of companies paying dividends:
+ Whether one looks at the S&P 500, the Russell 1000 or the Russell 3000, each of these widely followed market capitalization- weighted indexes has over 80% of its constituent weights in firms that have paid at least one dividend in the prior 12-month period. Ultimately, this tells us that dividend payers are becoming very significant parts of these indexes.
+ There were 140 additions to WTDI this year, and they contributed $11.1 billion to the Dividend Stream®. This year's rebalance saw the largest number of additions to the Index since WTDI inception, but the total number of constituents is still below its pre-recession highs. On the other hand, the percentage of market cap that WTDI constitutes within the Russell 3000 Index has surpassed previous highs.
+ Looking at the WTDI market cap as a percentage of the Russell 3000 Index market cap gives us an approximate percentage of dividend payers by market capitalization. As we can see, the percentage declined from approximately 78% to 70% as companies were suspending dividends to shore up cash during the recession. Since then, profitability has increased and companies have been reinstating or initiating dividends in order to return more cash to shareholders, as witnessed by the increase from 70% back to 78%. It is important to note that the Russell 3000 Index and WTDI have different methodologies and not all securities are represented in each index.
Although the number of payers and the market cap percentage of dividend-paying equities have grown, the number of equities with a dividend yield higher than the 10-Year Treasury yield has declined. Since the beginning of the year, longer-term interest rates in the U.S. have risen considerably-mostly driven by the expectation that the Federal Reserve would begin tapering its quantitative easing (QE) program, and the Fed did indeed announce it would scale back purchases of both mortgages and Treasuries by $5 billion a month. In the chart below, we look at how the relationship between the 10-Year Treasury and dividend-paying equities has changed over the past year, up to the most recent Fed announcement.
+ Rates Have Risen Rapidly: Through December 18, 2013, the 10-Year Treasury yield has increased from 1.76% to 2.89%-a change of 113 basis points. To put this in context, rates still remain well below their monthly average of around 6.0% over the last 30 years. But as interest rates increase, they provide more competition for dividend-paying equities, especially higher- yielding equities.
+ Dividend Yield Advantage Has Decreased: Within the S&P 500 Index, the weight of dividend-paying equities with an indicated divided yield above that of the 10-Year Treasury has decreased dramatically from 67% to 24%. WisdomTree Indexes have also seen a decline in weight, but still had a number of indexes with the majority of stocks having a higher dividend yield than the 10-Year Treasury.
+ Small Caps for Income: When investors think of dividends, they tend to think of mature large-cap companies as the primary source. As a result, we feel that many investors mistakenly overlook small-cap equities as attractive income options. We find it impressive that the WisdomTree SmallCap Dividend Index has more than twice the weight of the S&P 500 in stocks with a dividend yield higher than the 10-Year Treasury. WTSDI has over 50% of its weight in equities with a higher dividend yield than the 10-Year Treasury.
PART 4: THE 20 LARGEST DIVIDEND PAYERS IN THE UNITED STATES
+ Widespread Dividend Growth: Of the 20 largest dividend payers in the United States, 17 raised their indicated dividends per share over the prior 12 months. Not one of the top 20 payers reduced its indicated dividends per share between November 30, 2012, and November 30, 2013. These are also the 20 most heavily weighted constituents within WTDI, which illustrates one element of the WisdomTree rebalance: giving greater weight to companies growing their indicated dividends.
+ Dividends Well Covered: It is also worth noting that whether one views earnings or cash flows as the more important measure of potential dividend stability, these 20 firms, on average, have significant cushions. The average dividend coverage ratio is over 2.5x, while the average cash flow-to-dividend ratio is nearly 4.4x.
PART 5: ANALYSIS OF SECTOR SHIFTS IN SELECT WISDOMTREE DIVIDEND INDEXES
In what follows, we outline how the November 30, 2013, screening data impacted WisdomTree's U.S. Dividend Indexes. Each WisdomTree Index will compare its sector composition before the November 30, 2013, rebalance to its sector composition afterward. Additionally, each Index compares its underlying sector performance to the broad Index to look at the average performance of sectors that saw their weights increase or decrease. It is the interaction of dividend growth and price performance that provides the basis for determining which sectors tend to see increases or decreases in weight at the annual WisdomTree Index rebalance. Sectors that exhibit particularly strong performance must grow their dividends commensurately to maintain their weights. Sectors exhibiting weaker performance (assuming, of course, they're not reducing their dividends commensurately) could be more likely to have their weights increased.
+ The biggest increase in weight for any sector within WTDI occurred in Information Technology-an increase of 0.9%, which was driven by its dividend growth. The price performance for the sector was slightly below the Index performance, but the sectors dividend growth lagged only the Financials sector, hence earning a higher weight. Even after the rebalance, this still makes the sector roughly a 3.6% under-weight compared to the Russell 3000 Index.
+ The biggest weight reduction for WTDI occurred in the Industrials sector. Other weight reductions occurred in Health Care and Consumer Discretionary. All three sectors saw strong absolute and relative performance over the period, which made it harder for their dividend growth to keep pace.
+ Information Technology added 1.1% to its weight within WTLDI-the most of any sector-and has become the largest sector weight as a result. Even with a 1.1% increase in weight, the Information Technology sector is still under-weight compared to the S&P 500 Index. Again this weight increase was a result of strong dividend growth and slight relative underperformance, ultimately improving the relationship between price and dividends.
+ The greatest sector decreases in weight occurred in the Industrials and Health Care sectors-both sectors saw strong appreciation over the period but had dividend growth below the 11% year-over-year growth for the total dividend stream.
+ Four of the most heavily weighted sectors within WTHYE are Financials, Consumer Staples, Health Care and Utilities. Health Care, Utilities and Telecommunication Services each saw a reduction in weight, which we believe to be largely attributable to their price and dividend growth relationship relative to other sectors. Health Care saw significant performance over the year but had only average dividend growth. On the other hand, the Utilities and Telecommunication Services sectors both had poor relative performance, but they also had below-average dividend growth.
+ The Financials sector deserves special note within WTHYE, since it added over 7% to its weight as of the November 30, 2013, Index screening and became the largest sector represented. The mechanism driving this change was the above- average dividend growth of over 19% compared to last year's screening, shown in figure 1A. The Financials sector dividend stream has grown over 122% from its 2009 bottom, but it would still have to grow another 47% to surpass its 2007 highs.
+ Two of the largest additions, Telecommunication Services and Utilities, saw the poorest relative performance compared to the Index, while the two largest reductions, Information Technology and Industrials, had the greatest relative performance. This is a perfect example of how a fundamental rebalance helps manage risk by selling stocks that have potentially become expensive compared to their fundamentals and rebalancing back to areas of the market that have become cheaper compared to their fundamentals.
+ When considering this particular benchmark, it is important to call attention to Information Technology and Utilities. Information Technology had a 1.9% weight in the Dow Jones U.S. Select Dividend Index as of November 30, 2013, while Utilities had a 28.0% weight. Dividend indexes that rely on backward-looking criteria to screen for growth potentially miss out on the dividend growth opportunities from newer payers or growers, in this case the Information Technology sector. Also, dividend indexes that weight by dividend yield have the potential to concentrate their weight in certain sectors, as seen with a 28% weight in the Utilities sector. WisdomTree actually caps the sector exposures of its U.S. Dividend family of Indexes at 25% at each rebalance. Between rebalances, sector weights may fluctuate above 25% due to market activity.
+ The Energy sector received the largest addition in weight, increasing by 3.3%, even though it had slightly better relative performance compared to the Index. The Energy sector's above-average dividend growth over the period helped overcome its slight performance advantage, ultimately still improving the relationship between prices and dividends, hence earning a higher weight within the Index.
+ The Consumer Discretionary sector saw the largest reduction in weight within WTMDI, decreasing 3.9%. The sector also had above-average dividend growth over the period, but relative performance outpaced dividend growth, ultimately decreasing the relationship and earning the sector a lower weight in the Index.
+ The Utilities sector received the largest addition in weight, increasing 2.6%, while the Industrial sector saw the largest reduction, decreasing 1.9%. It is interesting to note that the performance differential between these two sectors is over 25%, with the Utilities sector suffering from the worst relative performance in the index while the Industrials sector had fairly strong relative performance over the period. The Industrials sector saw greater dividend growth compared to the Utilities sector over the past year, but it was not able to overcome the performance advantage, eventually causing the relationship between price and dividends to weaken compared to the Utilities sector.
+ The biggest increases in weight for any sector within WTDGI occurred in the Energy sector-an increase of 5.9%, which was driven primarily by the addition of Exxon Mobil (NYSE:XOM). The largest decrease in weight occurred in the Industrials sector-a decrease of 4.3%, which was driven primarily by the removal of Caterpillar Inc. (NYSE:CAT) and Deere & Co. (NYSE:DE).
+ It is important to note that the Information Technology and Consumer Staples sectors were both capped at the 20% sector limit-both sectors were among the fastest dividend-growing sectors over the past year. The Information Technology and Consumer Staples sectors have been leaders of dividend growth, contributing approximately 46% and 21%, respectively, of the total dividend growth for the WisdomTree Dividend Index. Although the Consumer Staples sector is typically represented among backward-looking dividend growth-focused indexes as a result of its long dividend history, these indexes typically exclude some of the largest dividend-paying information technology firms due to their limited growth history.
+ The Financials sector received the largest addition (8.8%) in weight, and the Health Care sector saw the largest reduction (4.5%) within WTSDG. The Financials sector exhibited above-average dividend growth over the period, while its performance lagged its peer sectors, ultimately increasing the relationship between price and dividends and earning a higher weight in WTSDG. The Health Care sector's dividend growth was not able to keep up with its strong relative performance, earning it a lower overall weight.
The WisdomTree annual rebalance is a key element of the added value of WisdomTree's Index methodology. We interpret another year of double-digit dividend growth as a very positive indicator of underlying market fundamentals and believe it helps provide a notable foundation for potential future gains.
We take comfort in the fact that the overall valuations of dividend stocks have not become overly stretched-our analysis found that valuation metrics showed dividend stocks being cheaper on average on an earnings and quality basis. Just as critical, it is at each rebalance when WisdomTree engages in a disciplined process to adjust weight based on changes in relative value as well as in the relationship between dividend growth and price growth. The newly refreshed Dividend Indexes thus provide important benchmarks for gauging the performance of different cross sections of the dividend-paying universe.
Jeremy Schwartz, Director of Research. As WisdomTree's Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel's head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper "What Happened to the Original Stocks in the S&P 500?" and the Wall Street Journal article "The Great American Bond Bubble."
Christopher Gannatti, Research Analyst. Christopher Gannatti began at WisdomTree as a Research Analyst in December 2010, working directly with Jeremy Schwartz, CFA®, Director of Research. He is involved in creating and communicating WisdomTree's thoughts on the markets, as well as analyzing existing strategies and developing new approaches. Christopher came to WisdomTree from Lord Abbett, where he worked for four and a half years as a Regional Consultant.
Unless otherwise stated, data source is WisdomTree.
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