growing a portfolio with dividend growth stocks growing a portfolio with dividend growth stocks ......

Industry Insights From Morningstar® Indexes Growing a Portfolio

with Dividend Growth Stocks

2 Growing a Portfolio with Dividend Growth Stocks

Dividend growth investing has gained market traction in recent years, yet it still inhabits a misunderstood way station between its two more popular namesakes. Unlike dividend investing, it does not seek to generate a considerable stream of income from equities. Unlike growth investing, it is not about finding the next Starbucks circa 1994 or buying Facebook at its IPO.

Instead, think of dividend growth as a core, total return-focused equity strategy with a defensive

bent. Companies capable of increasing cash payments to shareholders are typically sturdy. They

may lag during market rallies, especially ones that favor cyclical, economically sensitive businesses.

But dividend growers tend to preserve capital relatively well in downturns. This low volatility

approach to equity markets can outperform over a full market cycle.

Dividend investing is buttressed by a strong theoretical foundation, with dividend growth a key

driver of long-term equity returns. Empirical validation comes through an examination of the

Morningstar US Dividend Growth Index. Holdings-based analysis demonstrates superior exposure

to traits like quality and financial health and more sector-level diversification than a typical

high-yield equity income strategy. Returns-based analysis reveals a performance pattern character-

ized by superior downside protection, less upside participation, and an attractive long-term

risk/reward profile.

Why Dividends?

From the days of the Dutch East India Company, dividends have been central to equity investing.

Dividend payments represent a way for investors to extract value from their portfolio without selling

shares. Dividends constitute hard proof that a company is generating cash. In contrast to earnings,

dividends are difficult to massage or engineer.

Several studies over the years have demonstrated that dividend-paying stocks possess a perfor-

mance advantage over their non-paying counterparts. Robert Litzenberger and Krishna

Ramaswamy of the University of Pennsylvania’s Wharton School of Business observed that stocks

paying above-average dividend yields tend to produce superior performance.1 Jeremy Siegel,

also of Wharton, published another seminal study demonstrating that the highest yielding stocks

in the US market outperformed the overall market by a substantial margin from 1958-2003.2

London Business School professors Dimson, Marsh, and Staunton conducted an even longer obser-

vation, looking at capital market returns in four continents and 16 countries over a 101-year

period, 1900-2001.3 Their findings show that while in the short term, the impact of dividends can be

easily overlooked because stocks are volatile, over the long term, the compounding effect of

reinvested dividends contributes a substantial portion of equity market total return.

1 Litzenberger, Robert H., and Krishna Ramaswamy, June 1979, “The Effect of Personal Taxes and Dividends on Capital Asset Prices: Theory and Empirical Evidence”, Journal of Financial Economics 7, 163-195

2 Siegel, Jeremy, The Future For Investors (Crown Business, 2005)

3 Dimson, Marsh, and Staunton, Triumph of the Optimists (Princeton University Press, 2002

Dan Lefkovitz Content Strategist


Why do dividend paying companies outperform? Several factors are likely at play. To commit to a

dividend payment, corporate management must be confident of future cash flows. Once a dividend

commitment is made, it’s not withdrawn lightly. The market usually punishes dividend cuts or

eliminations severely because they indicate financial distress. Thus dividend-paying companies tend

to be competitively well-positioned, cash-generating businesses.

Additionally, the dividend commitment imposes discipline on executives and directors. Rather than

using free cash flow to fund acquisitions of questionable value, buy back shares at prices of

unknown attractiveness, hoard cash, or fund speculative growth initiatives, dividends put cash back

in the hands of shareholders.

Paying out a dividend fosters shareholder loyalty. If investors are relying on their equity not just for

capital appreciation but also for income, they will be likelier to hold on. They have less reason to bolt

at the first earnings disappointment, an unexpected management change, or unflattering headlines.

Why Dividend Growth?

Investors targeting dividend growers are not homing in on the market’s juiciest yields. In fact,

a dividend-growth portfolio typically sports a yield that doesn’t vastly exceed that of the

overall market. Rather, dividend growers are companies whose cash flows have translated into

a rising payout.

From an investor’s standpoint, dividend growth determines the extent to which equity income

will keep pace with the inflation rate. A rising dividend is fundamental to investors’ ability

to preserve purchasing power through their equity portfolio. Unsurprisingly, companies whose

dividend payments increase at a rate that outstrips inflation become more attractive to own,

boosting their share price.

Dividend growth is fundamental to equity valuation. The Gordon Growth Model breaks stock price

into three components: the dividend rate, the dividend growth rate, and a required return.

Especially for stocks with subdued current yields, the prospect of dividend growth is a fundamental

driver of share price fair worth.

If compounding works magic on a flat dividend payment reinvested, its impact on a growing income

stream is even greater. At the aggregate level, it is a key driver of equity market return. In fact,

Dimson, Marsh, and Staunton identified dividend growth as a fundamental pillar of long-term stock

market appreciation across the 16 countries they studied.

Like the dividend commitment itself, a track record of dividend growth sends a powerful message.

Executives who raise their firms’ dividend payments signal their interest in continually

rewarding shareholders.


Consider the example of Emerson Electric, a 125-year-old diversified industrial company whose

portfolio includes HVAC products and other large-scale automation systems. Thanks to

patents, regulatory approvals, and an entrenched customer base, Emerson generates substantial

free cash flow.

Emerson boasts an enviable 60-year history of growing its dividend payment to shareholders. That

said, it is a cyclical business whose fortunes wax and wane with the global economy. Its dividend

growth rate will therefore fluctuate. Emerson hiked its dividend by nearly 16% in 2011; in 2016

its dividend growth rate was just 1.1%. Emerson’s long-term average of roughly 8% dividend growth

per year, however, is extremely strong. Emerson’s relative performance versus the broad market

changes depending on the start and end points, but from the beginning of 2000 through the end of

2016, returns looked good, with dividend growth a key driver.

Market Returns—Emerson Electric vs. Morningstar US Market Index

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000Emerson Electric Co Morningstar US Market TR USD

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2000 2016

Data as of December 31, 2016 Source: Morningstar

Pitfalls of Dividend Investing

Conventional wisdom holds that interest rates are bad for dividend-paying stocks. While the nega-

tive effects of rising rates on equity income is debatable—high-yielding equities have actually

outperformed the market during some periods of rising rates such as the mid-1970s—it’s likely that

dividend growth will be less sensitive to rates. A high-yielding utilities stock intuitively becomes

a less attractive income source when yields rise on bonds, a less risky asset class. Because dividend

growers tend to sport more modest yields, they were never the first choice for yield hounds.

Dividend sustainability is a more pertinent consideration. A “dividend trap” is a stock that lures

investors with a juicy yield, only to result in a dividend cut or financial distress. Buying stocks with

high yields can be risky. When a stock’s price declines, its yield rises. So hunting for dividends

can lead an investor to troubled sectors, industries, and securities—think banks in 2007 or energy

and basic materials in 2014.

5 Growing a Portfolio with Dividend Growth Stocks 5 Document Title

Just because a company has raised its payout steadily over time does not mean the trend will persist

into perpetuity. A company might boast a record of increasing its dividend payment by 15% per year,

but such a growth rate might be unsustainable. Companies that try to maintain a blistering pace

can lose steam and fail to finish the race. Kinder Morgan and ConocoPhillips raised dividends when

they were flush with cash from high oil prices, only to cut them in 2016 amidst oil price weakness.

A company’s payout ratio, the proportion of profits paid out to shareholders in the form of dividends,

is therefore a critical determinant of dividend safety. The median payout ratio for the U.S. market

in the post-World War II era of 50% implies that half of earnings are paid out in dividends. A higher

payout ratios means higher dividend payments, which is good. A company with a small payout

ratio is using its earnings for something other than returning cash to shareholders, and the return on

those investments should be questioned.

But if a company’s payout ratio is too high, it lacks a buffer. A company with a 100% payout ratio

has no margin for error. If profits slip, the dividend may need cutting. Thus, a sweet spot exists,

where the payout ratio generously rewards shareholders but also provides a margin of safety for the

company should business conditions deteriorate.

The Morningstar US Dividend Growth Index

The Morningstar US Dividend Growth Index provides exposure to companies with a history of

dividend growth and an ability to sustain it. The Morningstar US Dividend Growth Index was created

in 2014, with back-tested returns starting in 2003.

The index uses several screens. First, it culls the U.S. equity market for securities that pay qualified

dividends. This excludes real estate investment trusts. Constituents must exhibit a five-year history of

increasing their dividend payments. To gauge the sustainability of dividend growth into the future,

eligible constituents must display positive consensus earnings forecasts from the analyst community.

As a safeguard against dividend cuts and financial distress, stocks with indicated dividend yield in

the top 10% of the universe are excluded. Finally, existing constituents are allowed to remain if they

have recently bought back shares and have not decreased their dividend payment.

Constituents must also have reasonable payout ratios. Companies with payout ratios above 75%

are ineligible. This screens out companies with unsustainably high dividend growth rates. To control

risk, the index caps the weights of individual constituents at 3% at the time of reconstitution.

Constituents are weighted according to a fundamental, dividend-based system. The index uses an

available dividend model that emphasizes company size as well as dividends.

Morningstar calculates available dividends for each stock by multiplying indicated dividend per share

by the number of shares available for purchase (the float). This weighting system retains the

primary benefits of market cap weighting (low turnover and scalable investment capacity). It also

tends to anchor the index in the shares of relatively stable mega-cap companies.

The index is reconstituted—that is, index membership is reset—annually. The index is

rebalanced—i.e. security weights are adjusted—quarterly.


Morningstar US Dividend Growth Index Construction Process

g Listed on NYSE, NASDAQ, & NYSE Amexg Common Stocks

g Top 97% Market Capitalization Coverage

g Qualified Incomeg 5-Year Uninterrupted Dividend Growthg Payout Ratio <75%

Morningstar Investable Universe Morningstar US Market IndexMorningstar®US Dividend Growth IndexSM

Source: Morningstar

Holdings-Based Features of the Morningstar Dividend Growth Index

The Morningstar US Dividend Growth Index displays several distinguishing characteristics compared

with both the overall market and its highest yielders. The Morningstar US Market Index, whose

1,500-plus constituents covering 97% of equity market capitalization, reflects the broad U.S. equity

market. The Morningstar Dividend Composite Index captures the performance of all stocks in

the US Market Index that have a record of making dividend payments, screened for sustainability,

and weighted by available dividends. It can broadly be considered to represent “dividend beta.”

First, as of early 2017 Dividend Growth sports a yield higher than that of the overall market

but lower than Dividend Composite. Investors seeking current income have better options than

Dividend Growth.

Dividend Yield—Morningstar US Dividend Growth vs. US Market vs. US Dividend Composite

IndexDividend Yield

(%)

Morningstar® US Dividend Growth IndexSM 2.46

Morningstar® US Market IndexSM 1.88

Morningstar® US Dividend Composite IndexSM 2.70

Data as of March 31, 2017. Source: Morningstar


Portfolio Analysis Dashboard

Next we observe the three indexes on a Holdings-Based Style Map that plots the weighted average

of portfolio holdings on the Morningstar Style Box, with Y axis positioning driven by market

capitalization. On the X axis is valuation, incorporating measures like price/earnings and price/book.

Both Dividend Growth and Dividend Composite skew to larger stocks than the overall market.

This is intuitive given that dividend payers tend to be more established companies. Both dividend-

focused indexes lean toward value, with Dividend Growth falling between the overall market

and Dividend Composite in terms of constituent valuations. Dividend-paying companies are tradition-

ally found in slower-growing industries. Fast-growing biotechs or popular retailers are less likely to

pay dividends than banks and well-established electricity suppliers.

Holdings-Based Style Map

Deep Value Core Value Core Core Growth High Growth

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Mid

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ant

Morningstar US Div Composite

Morningstar US Dividend Growth

Morningstar US Market

Data as of March 31, 2017 Source: Morningstar

From a sector weight perspective, Dividend Growth’s portfolio bears more similarity to the market

than does Dividend Composite. The March 2017 portfolio sports an overweight to healthcare

relative to both the market and the dividend stock universe. Relative to Dividend Composite, it is

underweight telecom and utilities. Its sector exposures are closer to those of the market with

respect to consumer stocks, technology, and energy.


Sector Weightings (%)

IndexMorningstar US Dividend

Growth IndexMorningstar US

Market IndexMorningstar US Dividend

Composite Index

r Basic Materials 4.28 3.40 3.37

i Comm. Services 1.08 3.75 7.50

t Cons. Cyclical 9.90 11.69 9.14

s Cons. Defensive 13.93 8.59 15.03

o Energy 4.01 6.23 0.51

y Fin. Services 16.00 15.90 16.96

d Healthcare 16.71 13.38 11.76

p Industrials 14.12 10.92 14.56

u Real Estate 0.01 3.71 0.01

a Technology 15.95 19.23 13.87

f Utilities 4.00 3.20 7.30


The Morningstar Global Risk Model is another useful tool for illuminating Dividend Growth’s funda-

mental characteristics. The Risk Model, launched in mid-2016, tracks stocks’ exposure to 36

different factors, or sources of return. The Risk Model is relative not absolute. Zero is average for the

universe. Index-level scores are weighted roll-ups of constituent-level scores.

Two factors, economic moats and financial health, are germane to the analysis of Dividend Growth.

An economic moat is a measure of quality. Morningstar equity analysts assign moat ratings to stocks

that possess a sustainable competitive advantage capable of generating excess returns over time.

An algorithm then extrapolates from the 1,500-stock coverage to assign quantitative measures of the

strength and stability of competitive advantages to a universe of 45,000 stocks. Morningstar has

found that a portfolio tilted toward strong moat companies would have generated relatively stronger

returns during the 2008-09 downturn.

Financial Health is based on the Quantitative Financial Health metric designed to assess the

strength of a firm’s financial position and ranks. It ranks companies on the likelihood that they will

tumble into financial distress by considering leverage and equity volatility. Higher scores

imply stronger financial health and therefore a lower risk of bankruptcy. Morningstar has found that

financially stable firms tend to perform best relative to financially unsound firms during a

crisis. From 2003 to 2015, the financial health factor exhibited a premium relative to the market.

Dividend Growth sports a higher aggregate Economic Moat score than Dividend Composite and the

overall market. This means its constituents tend to be more favorably positioned, their profits more

insulated from competition.


Dividend Growth also scores higher than Dividend Composite and the overall U.S. equity market on

Financial Health. Its constituents tend to have robust balances sheets and relatively low share price

volatility. The payout ratio screen no doubt contributes to this result.

Risk Factors Scores: Economic Moat & Financial Health

IndexRisk Factors Portfolio:

Economic MoatRisk Factors Portfolio:

Financial Health

Morningstar® US Dividend Growth IndexSM 1.37 0.71

Morningstar® US Market IndexSM 1.28 0.67

Morningstar® US Dividend Leaders IndexSM 1.07 0.55


Returns-Based Features of the Morningstar Dividend Growth Index

Dividend Growth has a solid return profile versus the overall market and the Dividend Composite

Index over trailing periods. It has beaten the market over the 1-year, 3-year, and 10-year periods

through March 31, 2017, and it tops Dividend Composite over the 10-year period. Over the 1-year and

5-year period its returns look competitive.

Trailing Returns (Month End)

Index 1-YearAnnualized

3-YearAnnualized

5-YearAnnualized

10-Year

Morningstar® US Dividend Growth IndexSM 18.09 10.57 13.16 8.96

Morningstar® US Market IndexSM 17.81 9.88 13.16 7.70

Morningstar® US Dividend Composite IndexSM 18.50 10.83 13.57 7.83



Investment Growth of $10,000

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

US Dividend Growth Index US Dividend Composite Index US Market Index

Data as of March 31, 2017 Source: Morningstar

A distinct performance pattern emerges when dissecting the track record. During big market

rallies (2003 to mid-2007 or March 2009 through April 2011, for example), Dividend Growth

posts strong absolute returns. But its blue-chip-heavy portfolios make it look sluggish relative to

the market. Lighter exposure to cyclicals has held it back during bull runs.

It is in down markets when Dividend Growth earns its keep. The financial crisis that began in late

2007 and lasted until early 2009 was an especially difficult time for high-yield stocks because of the

collapse of the banking industry. Dividend Composite lost more than the overall market. Dividend

Growth posted losses, to be sure, but it preserved capital better than the market. Its tilt toward high-

er quality stocks and sectoral diversification served it well. Companies with strong balance sheets

and superior competitive positioning weathered the storm better than most. Dividend Growth’s

maximum drawdown during the depths of the crisis was 43%. Meanwhile, the US Market Index lost

50.8% and the Dividend Composite Index lost 51.2%.

The smoother ride that Dividend Growth provides is evidenced through risk statistics. Dividend

Growth displays a lower standard deviation of returns (a measure of volatility) than the

market over the 3-year, 5-year, and 10-year trailing periods. It has been lower risk than the Dividend

Composite over the trailing 10-year period.


Volatility—Morningstar US Dividend Growth vs, US Market vs. Dividend Composite Index (Month End)

Index

Standard Deviation

1-Year

Standard Deviation

3-Year

Standard Deviation

5-Year

Standard Deviation

10-Year

Morningstar® US Dividend Growth IndexSM 6.90 9.94 9.70 13.74

Morningstar® US Market IndexSM 6.60 10.62 10.37 15.67

Morningstar® US Dividend Composite IndexSM 6.65 9.70 9.54 14.60


Conclusion

The record of dividend payers during rising rate environments is mixed. In theory, income-seeking

investors have less reason to flee dividend growers for higher yielding bonds because they did not

buy them for their rich dividends in the first place.

What’s more certain is that over the long-term, dividend growers tend to be solid, cash-rich

businesses that hold up well in down markets, participate in up markets, and are capable

of excess returns over a full market cycle. A dividend growth portfolio makes for a sensible core

portfolio holding. That’s especially true of a dividend growth strategy focused on financial

health and dividend sustainability. K

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