By Jeremy Schwartz CFA, Director of Research, & Eswarie Subrahmanyam S. Balan, Research Analyst
2013 marked a particularly strong year for equities in the developed international space, which, along with the United States, led the charge among global equity markets. Numerous macroeconomic tailwinds buoyed sentiment surrounding the developed international markets, including the eurozone returning to positive growth in the second quarter of 2013 and the Bank of Japan delivering bold monetary targets, reflecting overall accommodative monetary policies from central banks.
The developed international rally was underpinned, for the most part, by valuation multiple expansion, particularly on a price- to-earnings (P/E) basis. As valuations expand, we believe that having a process that focuses on sensitivities to relative valuations becomes increasingly important to add value. We subsequently analyze how WisdomTree's annual rebalance process impacted developed world indexes.
WisdomTree's developed international equity strategies draw on an annual screening process that typically rewards firms that have displayed growth in their dividends by increasing allocations to them. In addition, the process maintains an ongoing sensitivity to valuation by trimming exposure to firms that have displayed strong share price performance but have not grown their dividends proportionately.
Detailing The Developed International Dividend Stream
WisdomTree's rebalance process affords us the opportunity to take a deeper dive into the characteristics of the regional Dividend Streams. Figure 1 shows how the developed international dividends have evolved since dividends peaked at the May 31, 2008, annual index screening.
Trends in the Dividend Stream: The DEFA Dividend Stream has recently experienced two consecutive years of positive dividend growth. Despite the 12.8% dividend growth in 2014, the 2014 Dividend Stream must still grow 7.8% before it reaches its 2008 high of $630.1 billion.
Cumulative Growth in Dividend Stream: On a cumulative basis, the Dividend Stream has grown more than 39.1% since its low of $420.4 billion in 2009. Since the 2012 dip in the Dividend Stream, coinciding with the height of the eurozone crisis, the stream has grown by 18.2% cumulatively.
Regional Composition of Dividend Stream: The European region currently constitutes the largest portion of the $584.6 billion Dividend Stream, at 66.4%, followed by Pacific ex-Japan at 20.4% and Japan at 13.2%.
- Both Japan and the Pacific ex-Japan Dividend Streams reached new highs in 2014, but Europe needs to grow dividends by 21.9% in order to reattain 2008 peaks.
- At its peak, Europe formed 75.1% of the developed world's Dividend Stream, and its percentage composition bottomed in 2012, at 63.6%, before ticking up again.
Drivers Of The Developed International Dividend Stream Growth
Beyond regions, we break down the drivers of this 12.8% Dividend Stream growth in 2014. One immediate observation is the variability in dividend growth across both sectors and countries.
Drivers of Dividend Growth at the Sector Level: The fastest dividend growth came in two of the most cyclical sectors, Consumer Discretionary and Financials, which grew their dividends by 24.2% and 15.7%, respectively. Two of the more defensive sectors- Telecommunication Services and Utilities, also two of the higher-dividend-yielding sectors-had lower levels of dividend growth at 4.1% and 8.2%. The improvement in the Dividend Stream among cyclical sectors of the market may be a positive sign for continued momentum in the global economy.
Countries That Led Dividend Growth: Three of the 10 largest developed world countries had dividend growth above that of the broad DEFA Index, namely Spain, Switzerland and Japan, which each grew dividends by more than 20%.
Strong Equity Performance Underpinned By Multiple Expansion
Before analyzing the changes that occurred at the annual rebalance, we characterize the market's performance since the prior rebalance and how that compares to earnings and dividend changes. Interestingly, the market looks to have gotten more expensive on a price-to-earnings ratio basis, whereas dividends kept pace with price gains in many of the developed markets.
Notable P/E Expansion in Developed International Markets: Immediately following last year's rebalance, the WT DEFA Index sold at 12.0x estimated earnings. A year later, the multiple increased to 14.4x estimated earnings. This 19.7% multiple expansion represented a large part of the 23% change in the WT DEFA Index price levels as earnings only grew 2.5% in a similar period. P/E multiple expansion largely characterized equity performance across the Indexes listed above. The international small cap had the least multiple expansion on a P/E basis with the highest growth in earnings at 9.0%.
Dividend Multiple Expansion Explains a Large Portion of Price Performance: Yet another way to assess the nature of price performance is to study the growth in the price-to-dividend (P/D) multiple. In the international large-cap market, dividend growth perfectly tracked with price change, meaning that on a P/D basis the markets did not see a valuation expansion. The small-cap segment saw a small reduction in dividends and thus saw valuations expand there, which was in contrast to earnings trending higher. This might suggest that dividends should be supported in the coming year from this segment-given good earnings growth.
In a market characterized predominantly by multiple expansion-at least on a price-to-earnings ratio basis, we believe it becomes more important to employ a process that helps reposition the Index into cheaper areas of the market and to be sensitive to valuations.
Rebalancing Toward Underperformers And Dividend Growers
A key distinguishing factor of WisdomTree Indexes is the rebalance process. Each year, the relationship between price performance and dividend growth is judged for each constituent. WisdomTree's dividends Indexes tend to decrease weight to firms where price appreciation outpaced dividend growth and add weight to firms where dividend growth outpaced price appreciation-finding potentially underappreciated segments of the market.
In Figure 4, we quantify the median dividend growth and total returns for companies that received increases or decreases in weight and compare that to the overall universe.
Increasing Weight to Faster Dividend Growers: For each WT Index listed above, the firms that experienced increase in weights exhibited median dividend growth rates that ranged from 7.9% to 22.2% more than the constituents that saw reduction in weights. It is additionally noteworthy that firms that have had their weights lowered also exhibited positive dividend growth, albeit to a lesser degree.
Reducing Weight to Outperformers: Firms that saw their weights reduced displayed higher median performance that ranged from 7.6% to 22.4% more than companies that saw their weights increase at the rebalance.
Large-Cap Stocks Lead Dividend Growth: Dividend growth was led by large-cap stocks over small caps, as the median dividend growth for the WT International LargeCap Dividend Index (WTILDI) was nearly 3% higher than the median dividend growth for the WT International SmallCap Dividend Index (WTISDI).
Dividend Growth Methodology Selects High Dividend Growers: WisdomTree developed a methodology, WT International Hedged Dividend Growth Index, that looks to identify companies with potential to raise dividends by selecting constituents on quality factors (high return on equity [ROE] and high return on assets [ROA]) as well as long-term earnings growth expectations. This Index delivered a median dividend growth that was more than 5% higher than the typical stock in the WT DEFA.
The annual rebalance is the time of the year when the WisdomTree Indexes make adjustments based on changes in relative value. In the section below, we will quantify how weights shift in an index, as well as give some examples of how country and sector weights can shift as a result of the performance and dividend growth of their underlying stocks.
Taking The Chips Off The Table - A Focus On The International Small Caps
In this segment, we quantify how the rebalance process repositions investors in the segments of the market that have appreciated much less, while taking chips off the table in segments that appreciated the most.
Strong Performance from Small Caps: In the 2013 calendar year, similar to the U.S. markets, MSCI EAFE's small caps beat the large caps by 7.4%. This makes the international small-cap segment an interesting one to evaluate in terms of how the portfolio was repositioned at the rebalance.
Banking the Strong Gains: The International SmallCap Dividend Index had nearly 22% in total returns between the annual screening dates. Prior to the May 31, 2014, screening date, more than 36% of its weight was in constituents that returned more than 40%. The weights to these securities were subsequently reduced by 10.8%.
Repositioning into Cheaper Areas of the Market: We see that weights were taken from firms that returned more than 40% and redistributed to firms that returned less than 20%, as this bottom performance bucket saw weight increased by 13.7%.
The act of taking the chips off the table is a particularly important story for the WisdomTree Indexes, especially in a year where market rallies were underpinned by multiple expansion. By taking weight away from the segment of the market that appreciated the most, the WisdomTree Indexes help manage valuation risk.
Zooming In On The Key Country And Sector Allocation Changes
A key focus at each annual rebalance involves a detailed look at how the mix of sectors and countries changes due to the emphasis on relative valuation that we have been describing. Below we analyze the key sectors that have changed within the WTISDI post- rebalance. The main takeaway is that the rebalance process tends to add weights to countries that have generally underperformed and reduce weights to those that have outperformed.
Outperformers in Europe: 9 of the 13 outperforming countries are in the eurozone. This is generally reflective of the optimism investors have toward the region. Each of the "peripheral European" countries (Portugal, Ireland, Italy and Spain) included in our developed world Indexes resides among these top performers.
Reweighting to Cheaper Countries: In aggregate, the outperforming countries saw weights reduced by 7.8%, which was subsequently shifted to the underperforming countries. Additionally, compared to the broader market cap-weighted MSCI EAFE Small Cap Index, WisdomTree's Index has a -26.9% underweight to countries that have outperformed.
An Emphasis on Japan-Weight Additions: Japan, the largest weight within the Index, was also the worst performer on country basis, up by only 11.3%. This country received the second largest addition to weight by 2.4%, following Australia.
Shifting gears to sector allocations, we evaluate the drivers of change at this rebalance for this same Index.
Less Dramatic Shifts on a Sector Level: On a sector level, the shift to relative underperformers was not quite as dramatic. On a country basis, the spread between the outperforming countries and underperforming countries was more than 30%. On a sector basis, the differentials were much more narrow-only 6%.
Shedding Weights in Outperforming Sectors: Five of the six outperforming sectors saw their weights reduced, led by a 1.5% reduction in Industrials. Separately, Industrials exhibited the best sector performance and is still the largest sector weight in WT International SmallCap Dividend.
Packing On Weights to Underperforming Sectors: Three of the four underperforming sectors saw weight increased, led by Consumer Discretionary.
High Cyclical Sector Exposure: One of the reasons international small-cap stocks are often thought of as more cyclical in nature than large caps is the high exposure to Consumer Discretionary and Industrials, which together make up approximately 45% of the new rebalanced Index, and relatively small allocations to more defensive sectors like Health Care, Utilities and Telecommunication Services.
Assessing Allocation Changes Across The Developed International Landscape
In the section above, we focused on the small-capitalization segment of the developed international space. Below, we showcase how the valuation sensitivity concept discussed above is transferable to all international developed indexes listed below. In particular, we hone in on the capability of the rebalance process to reweight securities away from outperforming countries and sectors into the underperforming ones.
Transferring Weights into Underperforming Countries and Sectors: The rebalance process, as we have previously discussed, transfers weights from the outperforming countries and sectors to the ones that have underperformed. This shift is demonstrated clearly in the table above, where the changes in weights within the countries and sectors that underperformed in the broad indexes are all positive. By extension, the weights are reduced to constituents whose countries and sectors have outperformed.
Moving down the Market Capitalization Structure Leads to Higher Cyclical Sector Exposure: The small caps have the highest cyclical sector exposure at 84.5% compared to the mid- and large caps at 75.8% and 60.8%, respectively. Hence, small caps remain the best vehicle to play a domestically led recovery story.
Currency Impact: While European exposure dwindles as we move from the large caps to the small caps, Japanese and Pacific ex-Japan exposure, on the other hand, increases. Many of the strategies listed above are unhedged in nature, and thus currency considerations become an important factor when investing. As a matter of fact, the cost of hedging the WT International Hedged Dividend Growth Index is minimal, at 0.3% annually. Currency hedging can serve to minimize volatility of the overall investment strategy.
Valuation Comparison Across Developed International Indexes
Given our focus on changes in relative valuation in this piece, we want to conclude the discussion by exploring the valuation characteristics of the WisdomTree Indexes following the rebalance. We note with the table below that the WisdomTree Indexes tend to exhibit lower P/E and higher dividend yields than their respective market cap-weighted benchmarks. This again is a byproduct of the rebalance process that instills the discipline of reweighting the Indexes as described above.
Attractive P/E Ratio and Dividend Yields: One of the greatest differentials in valuation multiples is within the small-cap space. We note that WTISDI relative to the MSCI EAFE Small Cap's P/E trades at an 18% discount, and its dividend yield is 1.54% higher. In fact, WTISDI's P/E ratio is the lowest when compared to the broader indexes.
Quality Measures Are Distinctly Higher: Compared to their respective market cap-weighted benchmarks, the WisdomTree Indexes have noticeably higher ROE and ROA. In fact, if we zoom in on the WT International Hedged Dividend Growth Index (WTIDGH), a methodology that ranks by both growth (long-term earnings growth estimates) and quality (ROE and ROA) measures, the Index exhibits the highest ROE and ROA estimates among its peers.
Sustainable Growth Rate Most Compelling for WT International Dividend Growth: The last column in the table signals the sustainable growth rate in earnings and subsequently dividends. This growth rate is a function of the dividend payout ratios coupled with ROE that measures efficiency in employing equity to generate earnings. The ratio indicates that WTIDGH has the highest sustainable growth rate among other indexes displayed in the table, while displaying a P/E multiple and dividend yield that are close to that of the MSCI EAFE. This is an attractive combination in our view.
Each year, the rebalancing process refreshes the constituent weights of WisdomTree Indexes back toward a measure of relative value. The added sensitivity to valuation through the annual rebalance becomes more important in years where we experience a multiple- led market similar to what we witnessed recently. As market participants hunt for value and income options in the developed world, we believe WisdomTree's rules-based approach and newly rebalanced dividend Indexes represent compelling options.
Unless otherwise stated, data source is WisdomTree.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. To obtain a prospectus containing this and other important information, please call 866.909.WISE (9473) or visit wisdomtree. com. Investors should read the prospectus carefully before investing.
Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty.
Investments focusing on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility.
Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments.
Past performance is not indicative of future results.
Dividends are not guaranteed, and a company's future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.
WisdomTree Dividend Index of Europe, Far East Asia and Australasia (WisdomTree DEFA Index): A fundamentally weighted index that measures the performance of dividend-paying companies in the industrialized world, excluding Canada and the United States, that pay regular cash dividends and meet other liquidity and capitalization requirements. It comprises companies incorporated in 16 developed European countries, Japan, Australia, New Zealand, Hong Kong and Singapore. Companies are weighted based on annual cash dividends paid. WisdomTree DEFA Equity Income Index: A fundamentally weighted index that measures the performance of dividend-paying companies in the industrialized world, excluding Canada and the United States, that pay regular cash dividends and are among the 30% highest-yielding equities within the WisdomTree DEFA Index as of the annual Index screening date. WisdomTree International Dividend ex-Financials Index: An index meant to measure the performance of relatively higher-yielding companies within the nine industry sectors outside of financials from the WisdomTree DEFA Index. Weighting is by trailing 12-month dividend yield. WisdomTree International LargeCap Dividend Index: A fundamentally weighted index that measures the performance of the large-capitalization segment of the dividend-paying market in the industrialized world outside the U.S. and Canada. The Index comprises the 300 largest companies ranked by market capitalization from the WisdomTree DEFA Index. Companies are weighted in the Index based on annual cash dividends paid. WisdomTree International MidCap Dividend Index: A fundamentally weighted index that measures the performance of the mid-capitalization segment of the dividend-paying market in the industrialized world outside the U.S. and Canada. The Index comprises the companies that make up the top 75% of the market capitalization of the WisdomTree DEFA Index after the 300 largest companies have been removed. Companies are weighted in the Index based on annual cash dividends paid. WisdomTree International SmallCap Dividend Index: A fundamentally weighted index that measures the performance of the small-capitalization segment of the dividend-paying market in the industrialized world outside the U.S. and Canada. The Index comprises the companies that make up the bottom 25% of the market capitalization of the WisdomTree DEFA Index after the 300 largest companies have been removed. Companies are weighted in the Index based on annual cash dividends paid. WisdomTree Australia Dividend Index: A fundamentally weighted index that measures the performance of high-dividend yielding companies in Australia. WisdomTree International Hedged Dividend Growth Index: Designed to provide exposure to the developed market companies while neutralizing exposure to fluctuations between the value of foreign currencies and the U.S. dollar. Comprises companies from the WisdomTree DEFA Index with the best combined rank of growth and quality factors. WisdomTree International Dividend ex-Financials Index: An index meant to measure the performance of relatively higher-yielding companies within the nine industry sectors outside of financials from the WisdomTree DEFA Index. Weighting is by trailing 12-month dividend yield. MSCI EAFE Index: A market cap-weighted index composed of companies representative of the developed market structure of 22 developed countries in Europe, Australasia and Japan. MSCI EAFE Small Cap: A free float-adjusted market capitalization-weighted equity index that captures small-cap representation across developed market countries around the world, excluding the U.S. and Canada. MSCI EAFE Value: A market capitalization-weighted subset of stocks within the MSCI EAFE Index that have lower share prices relative to their earnings or dividends per share. MSCI EAFE Growth: A market capitalization-weighted subset of stocks within the MSCI EAFE Index that have higher share prices relative to their earnings or dividends per share.
WisdomTree Funds are distributed by ALPS Distributors, Inc.
Jeremy Schwartz and Eswarie Subrahmanyam S. Balan are registered representatives of ALPS Distributors, Inc.
© 2014 WisdomTree Investments, Inc. "WisdomTree" is a registered mark of WisdomTree Investments, Inc.
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."