2023-06-19 03:41:34 ET
Summary
- Quality and dividend growth stocks are expected to perform well in a slowing economy.
- WisdomTree U.S. Quality Dividend Growth Fund ETF is the best-performing dividend growth ETF.
- These companies have strong balance sheets and low default risk, making them valuable during economic downturns.
We like quality stocks and dividend growth stocks. Both can be expected to perform when things get more difficult. The tough get going when the going gets tough. The best-performing dividend growth ETF is the WisdomTree U.S. Quality Dividend Growth Fund ETF ( DGRW ), which is both a dividend growth and a quality ETF.
Equity factor performance
10 year US treasury yields peaked in October of last year at 4.25%. Since then, yields fell back to the current level around 3.75%. As a result, and also fuelled by the AI boom, Growth became the best-performing equity factor.
Those "long-duration" growth equities were no longer negatively impacted by rising rates. Dividend stocks sit on the other end of the duration spectrum and hence less positively impacted by the lower rates. Dividend growth stocks are more "growth" and have a higher duration than high dividend stocks. This can be an explanation for why dividend growth stocks outperformed high div equities in the past months.
Dividends always play an important role in the total returns of investment portfolios. This is less the case when the price appreciation of equities is high. Dividend growers are a low-beta investment. In bull markets, they perform well but underperform the broader market. This is currently the case. In down markets, they have a negative return, but the outperformance is so outspoken that overall they come out on top.
These companies have a strong track record of generating consistent cash flow, which allows them to pay dividends even during challenging economic times.
The same can be said of quality stocks. Quality stocks have strong balance sheets and hence low default risk. When the economy slows down, this is a valuable feature.
Quality tends to outperform when the Fed ends hiking rates and when the economy is slowing down or is in recession. This describes the current market backdrop quite well. The Fed rate hikes are slowing down the economy.
The iShares MSCI USA Quality Factor ETF ( QUAL ) doesn't indeed take any sector bets compared to the S&P 500. As a result, the weight of technology growth stocks is almost 30%, which contributes to the good performance of quality stocks.
The Fed is still not done raising interest rates and keeps slowing down the economy. Both quality and dividend growth stocks can be expected to perform well when things get indeed more difficult.
At the intersection of quality and dividend growth
We like both quality and dividend growth stocks, and both are in a long-term uptrend.
Figure 4: Trends (Author)
The best-performing dividend growth ETF is the WisdomTree U.S. Quality Dividend Growth Fund ETF, which is both a dividend growth and a quality ETF. It's also the only dividend growth ETF that's able to outperform the S&P 500 over the past 12 months.
WisdomTree defines higher-quality companies as those that have displayed above-average historical returns on equity and on assets. Such companies are better able to fund growing dividends.
Dividends are more prevalent among large caps.
That's why WisdomTree selects for DGRW only companies whose market caps exceed $2 billion.
Figure 7: Market cap allocation (WisdomTree)
Non-dividend paying stocks are of course excluded, but also companies whose dividend coverage ratios are less than 1 (i.e., dividends exceed earnings) are removed from the universe. The exclusions of non-dividend payers and companies whose dividends exceed earnings or that are at risk of cutting their dividend payments offer already an important quality tilt.
The remaining companies are then ranked based on an equally weighted composite score of growth and quality, and the top 300 companies are selected for the portfolio. The quality score is calculated as a 50/50 score of the company's average three-year return on equity (ROE) and ROA. ROA penalizes the use of debt in delivering ROE and adds an additional layer of quality to the selection process.
The 300 companies selected are then dividend stream weighted. Below, you can find the 20 US companies with the biggest dividend stream.
And these names are reflected in DGRW's top 10 holdings.
Figure 9: Top 10 Holdings DGRW (WisdomTree)
An individual holding cap of 7% is applied prior to a 20% sector cap for all sectors except Technology (25%) and Real Estate (10%). Thanks to the nice performance of Technology, the weight drifted to almost 30% since the last rebalance at the end of last year.
Figure 10: Sector allocation DGRW (WisdomTree)
Below you can find the 10 biggest Technology positions. Nvidia (NVDA) isn't part of the top 10 holdings of DGRW's portfolio, but it is in the top 10 of Technology holdings.
Figure 11: Top 10 Technology Holdings DGRW (WisdomTree)
The below chart compares DGRW's portfolio characteristics versus those of the S&P 500 after the latest rebalance at the end of 2022.
Figure 12: Portfolio characteristics (WisdomTree)
DGRW's ROE exceeds the S&P 500 by more than 7%, and the median estimated growth of the portfolio is close to 2% higher. Almost half of the weight is allocated to the highest ROE companies.
The forward valuation is lower, and the dividend yield is 62 bps higher than the S&P 500.
A higher quality and dividend growth coupled with a lower valuation is the right recipe for both an outperformance and a lower risk.
Figure 13: Portfolio characteristics (WisdomTree)
DGRW has an expense ratio of 0.28% and the current dividend yield is 2%. DGRW is in a strong long-term uptrend.
Since the end of last year, DGRW is no longer in a long-term downtrend, and since a couple of weeks, it's in a long-term uptrend (as you can see in the ribbon on the price part of the below graph).
Conclusion
When things get more difficult economy-wise, quality, and dividend growth stocks in general and DGRW, in particular, can be expected to keep performing well. These companies have a strong track record of generating consistent cash flow, which allows them to pay dividends even during challenging economic times. When the economy slows down, strong balance sheets and low default risk are valuable features.
Both quality and dividend growth stocks are performing well and are in a long-term uptrend. It comes as no surprise that the WisdomTree U.S. Quality Dividend Growth Fund ETF is the best-performing dividend growth ETF. Buy!
For further details see:
DGRW: The Only Dividend Growth ETF That's Outperforming The Rising S&P 500