The recent closing of the Vanguard Dividend Growth (VDIGX) fund to new investors might be a sign that things might be changing for dividend-oriented investors. Vanguard indicated the move was made to “control asset growth.” Fund companies that close funds when they become too big should be congratulated for putting the interests of the fund's shareholders first and it is no surprise that Vanguard would do this.
In a recent column for MarketWatch Chuck Jaffe said, “While a dividend-growth strategy has paid off, it’s important to have reasonable expectations for it." Josh Peters, editor of the Morningstar DividendInvestor newsletter, recently noted that dividend-growth investing has returned almost 6% per year on average since 2003. But he cautioned, “The golden era of dividend growth is over.” (For more, see: Are Dividend Stocks a Good Substitute for Bonds?)
Is the 'Golden Era' Over?
In a recent article on Morningstar.com, Peters went into some detail as to why he thinks the golden era of dividend investing might be coming to an end. He cited:
- A slowing in the growth of dividends.
- A slump in earnings per share coupled with growth in dividends per share.
- A payout ratio for the S&P 500 that is right at the historical post-World War II median even in the face of falling earnings per share.
During the first quarter of 2016 the growth of dividends per share slowed to an increase of 4.6%, the smallest in years. Morningstar’s Peters indicated that, “In 32 of the 49 quarters between the first quarter of 2003 and the first quarter of 2015, the year-over-year growth rate for dividends per share for the S&P 500 has been at least 10%: frequent enough for investors to treat double-digit dividend growth as normal, something that can be taken for granted.” The article goes on to say that the 12-year growth rate averaged 5.9% per year, even when taking the precipitous decline in dividends during the 2008 financial crisis. (For more, see: With Rates Low, Where Can Advisors Find Yield?)
Part of the recent slowdown in the growth rate is certainly attributable to the difficulties that many energy-sector companies have had, driven by the drop in oil prices.
Lower Earnings Per Share
S&P 500 earnings per share have declined since 2014, while dividends per share have continued to increase. If this trend continues, at some point these companies will see their dividend payout ratios become unmanageable.
There is also the issue of where actual 2016 earnings will come in versus the current estimates. Peters points out that estimates for the last two quarters of the year remain on the high side. For the past 70 years the annual growth in earnings per share of the S&P 500 has been about 2.8%.
Why are Payout Ratios Important?
Peters indicated in the Morningstar piece that the current payout ratio of the S&P 500 was about 50%, which is in line with the median historical level post-World War II. This is well up from a low point of 29% during 2011. This figure is a bit deceiving in that the cause of this is more due to a drop in earnings rather than an increase in dividends per share. (For more, see: These Bond Funds Act Like Stocks.)
At some point companies can only payout so much of their earnings as dividends. A company that continues to maintain its dividend per share level even as earnings decline or they lose money may actually need to borrow to pay the dividend. This should be a red flag for potential investors.
Peters makes the point that he feels that the current level of payout ratios may constrain the future growth of dividends for the market as a whole. He reasons that far fewer companies have more “catching up” to do in terms of their payout ratio. He also makes the point that the level of future corporate earnings growth is questionable. And to boot, some of the past earnings growth has been fueled by stock buybacks. These tend to be more prevalent when companies are flush with cash.
Dividends are Hot
- The iShares Select Dividend ETF (DVY) gained an average of 12.39% over the three years ended July 31, 2016 versus 11.16% for the S&P 500 Index. This ETF invests in the 100 highest-yielding stocks in the S&P 500 and could be considered a smart beta ETF.
- The previously mentioned Vanguard Dividend Growth fund slightly trailed the index over the three years ending July 31, 2016 with an average annual gain of 10.58%. The fund invests in higher-quality stocks.
- The Vanguard Dividend Appreciation Index Fund ETF (VIG) trailed the index over the prior three years gaining an average of 9.18% per year through July 31, 2016. However year-to-date through July 31, the fund was up 10.66% versus 7.66 for the S&P.
These funds generally trail the broad S&P 500 Index in up markets and hold up better in down markets.
Dividend funds and ETFs have been popular with investors over the past couple of years as evidenced by the closure of the Vanguard fund. Investment manager Rob Arnott has made the point that the valuations of a number of smart beta ETF strategies have been bid up and are in danger of becoming overvalued. Dividend strategies have enjoyed such a run-up as part of the overall wave of gains by value strategies that also includes low volatility. (For more, see: Tips for Assessing a Client's Risk Tolerance.)
In looking at the valuation and expected excess return (the alpha it is expected to deliver above its current price, the ETF’s fair value and the risk profile of the ETF’s portfolio) as calculated by Morningstar, we find further evidence that many of these ETFs are fairly valued:
- The iShares Select Dividend is rated as fairly valued with an expected excess return of -0.47%.
- The Wisdom Tree Total Dividend ETF (DTD) is rated as fairly value with an expected excess return of -0.36%.
- The Vanguard Dividend Appreciation is rated as fairly valued with an expected excess return of -0.20%
While this doesn’t say that these ETFs and others don’t have room to move higher, they are fairly valued.
The Bottom Line
Dividend stocks, ETFs and mutual funds have been hot of late. There are signs that many of the dividend-oriented ETFs may be fully valued and may not have much upside. This may be a reflection of dividend stocks as a whole and something for financial advisors to be aware of when building clients' portfolios. (For more, see: The Top Dividend-Paying Stocks of 2016.)