Seeking Alpha

Don't Be Fooled By High Dividend Growth

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Includes: BANR, SCHD
by: Kurtis Hemmerling
Kurtis Hemmerling
Investment model designer, Quantitative screening, Historical backtesting
Summary

High trailing dividend growth does not translate into long-term high dividend growth.

I run single-factor tests to highlight how buying stocks with high trailing dividend growth results in lower dividends and lower total returns.

SCHD uses 4 factors for their dividend stocks and I suggest that only 3 are useful.

If you are a dividend investor, chances are you care a great deal about how big you can grow that dividend stream for retirement. And if you analyzed a successful dividend portfolio ex-post, you would likely find a robust dividend growth rate over many years.

Fast Growing Dividends Make Large Income Streams

So if we want to grow the dividends in our portfolio by the largest amount possible, why in the world would we want to ignore the dividend growth rate? The reason is that high trailing dividend growth does not forecast sustainable future dividend growth. In fact, evidence points to the opposite. If you want a portfolio of big dividend growth, you should probably shy away from stocks with high trailing dividend growth rates.

High Growth Is Not Sustainable

In 2012, Banner Corporation (BANR) paid out $0.04 in dividends. That number jumped to $1.83 in 2018. We are talking about a compound annual growth rate of 89%. If that keeps up, the dividend will be 1.5x larger than the current share price in 6 years. But how liable is that to happen?

Large dividend growth rates are typically a function of a tiny dividend getting into an average range. It really isn’t anything to get excited about. And it does not seem to indicate meaningful forward growth. Instead of an indication of a long-term trend, high-growth is more like an adolescent going through a growth spurt. Just because a teenager grew two inches in 6 months, this doesn't mean he will be a giant. It's just his growth phase.

A Case Study of PowerShares High Growth Rate Dividend Achievers Portfolio ETF

The year was 2005 and it seemed like a great idea to build an ETF around the concept of big dividend growth. Below is a blurb on the PHJ ETF:

The PowerShares High Growth Rate Dividend Achievers Portfolio Fund seeks to replicate the High Growth Rate Dividend Achievers Index, which is designed to identify the 100 Dividend Achiever companies with the highest 10-year annual dividend growth rate. These companies have increased their annual dividend for ten or more consecutive fiscal years. The portfolio is rebalanced quarterly and reconstituted annually.

Great idea, no? No. Look at the performance of the ETF since it was launched and shut down. I compared it to the Vanguard Dividend Appreciation ETF (VIG).

High Dividend Growth ETF versus VIG

It didn’t hold up very well in the bear market.

Factor Analysis Using The Schwab U.S. Dividend Equity ETF

But that is just one anecdotal piece of evidence. What do we find when we dig a little deeper with factor analysis? To illustrate this, I used the Schwab U.S. Dividend Equity ETF (SCHD) as my example.

SCHD is drawn from a 100 stock sub-set of the Dow Jones U.S. Broad Market Index. I attempted to replicate that index as close as I could. My objective was to examine the equal-weight return of a similarly created index and then compare the equal-weight returns of the top 100 stocks according to the 4 factors that SCHD uses to select stocks. Think of the benchmark versus the top 100 stocks according to dividend yield, dividend growth, return on equity and cashflow to debt.

Below is what I found. The test starts in 2002 and runs until mid-December 2018. The portfolios are reconstituted and rebalanced annually.

Total Return 2002-2018

Annual Return

Max Drawdown

Sharpe

Dividend Yield

Yield On Cost

S&P 500 (SPY)

212.68%

6.95%

-55.42%

0.49

Base Dividend Universe

330.87%

9.00%

-56.60%

0.59

2.87%

12.4%

Top 100 Dividend Yield

288.71%

8.34%

-68.01%

0.5

7.38%

28.7%

Top 100 Dividend Growth

209.77%

6.90%

-57.38%

0.45

2.50%

7.7%

Top 100 Cashflow / Debt

378.68%

9.67%

-48.92%

0.64

2.41%

11.5%

Top 100 Return On Equity

387.26%

9.79%

-50.40%

0.67

2.94%

14.3%

4 Factors Equal-Weight

433.68%

10.38%

-45.30%

0.73

3.29%

17.6%

3 Factors Equal-Weight

521.15%

11.37%

-45.02%

0.81

4.06%

25.2%

Just by requiring our stocks to have 10 years of dividend history and by removing smaller stocks with lower liquidity, the long-term compound annual growth rate is over 2% higher than the S&P 500 (see base dividend universe).

Next, I created sub-portfolios of 100 stocks each based on each of the 4 factors that make up SCHD. Here are some of the findings:

  • The top 100 dividend yielding stocks produced over 2x the yield on cost as the average of the dividend universe. However, this is simply a function of higher yielding stocks (not growth) since the current dividend yield was 2.5x as high with total return under-performance.
  • Selecting the top 100 high dividend growth stocks resulted in 2.1% less annual performance than the base universe. This is significant. It also resulted in a very low yield on cost of only 7.7% despite this portfolio starting in 2002.
  • Cashflow to debt and return on equity factors both increased returns modestly and lowered maximum drawdown. Yield on cost was modestly higher as well.
  • A ranking system that selects the top 100 stocks equal-weight based on the 4 SCHD factors had a superior total return than any of the 4 factors in isolation.
  • If they would have used a 3-factor ranking system and removed dividend growth as a factor, the total return and the yield on cost would have among the best.

The take-home message is that scanning for stocks with high dividend growth hurts the dividend stream and the total return. But who cares about total return? Total return has some merit even for dividend investors as at any point you can switch holdings and buy defensive stocks with low upside potential but with sufficient dividend yield. On the other hand, if you had followed the ‘high dividend growth’ strategy, you would be stuck with a lousy income stream and few options to improve it. You are either forced to have a fraction of the income stream you otherwise could have or you can start investing in very risky stocks at retirement in a futile effort to boost it.

More Proof That High Trailing Dividend Growth Lowers Future Growth

This last diagram holds an equal-weight portfolio of the top 100 stocks based on the 3 good factors of SCHD, while filtering out stocks below a certain threshold of dividend growth. Here is the result.

Total Return 2002 - 2018

Annual Return

Max Drawdown

Sharpe

Dividend Yield

Yield On Cost

3 Factor & Div Grow >0

517.91%

11.34%

-44.06%

0.82

3.83%

23.7%

3 Factor & Div Grow >5

485.51%

10.99%

-45.73%

0.78

3.35%

19.6%

3 Factor & Div Grow >10

444.72%

10.51%

-45.73%

0.73

3.00%

16.3%

3 Factor & Div Grow >15

321.02%

8.85%

-51.99%

0.58

2.76%

11.6%

3 Factor & Div Grow >20

240.88%

7.50%

-52.78%

0.48

2.45%

8.4%

What does this show? That as we require our portfolio to have an increasing minimum of trailing dividend growth over the past 5 years, our annual returns drop as well as our yield on cost.

Summary

What is the take-home message? That trailing dividend growth doesn't forecast long-term future dividend growth. It is probably just a function of a very low dividend being raised to an average sized one. But don't expect to buy stocks with high dividend growth with the assumption that it will result in a large income stream.

If that is true, then to find the next big high growth stock that'll make us rich, we merely need to look at micro-caps making triple-digit earnings growth and project that forward 20 years. But turning $10 into $20 is a lot harder than turning $10 billion into $20 billion.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.