Recently, European markets have performed strongly, with many investors focusing on the economic recovery. It is becoming difficult to remember that a few short years ago there was widespread debate about whether the European Monetary Union (EMU) would continue to exist.
WisdomTree thinks it is important to remember that Europe represents a large share of the global markets. On a market capitalization basis, developed Europe makes up approximately 26% of the global opportunity set. At $345 billion of dividends paid as of last May 31, over 31% of global dividends came from Europe, which was greater than the sum paid by firms in the United States.1
The Opportunity: While the United States is setting new highs for its Dividend Stream®, Europe’s earnings and dividends—similar to the general European economy—are still catching up to their highs set prior to the 2008–09 global financial crisis. Europe needs dividends to grow at least 37% more before the aggregate dividends from these firms reach their 2008 levels.
WisdomTree thus believes the time is ripe to apply its proprietary dividend growth methodology to a universe of European stocks.
The Opportunity for Dividend Growth in Europe
Introducing the WisdomTree Europe Dividend Growth Index
The universe of eligible companies begins with the European countries in the WisdomTree DEFA Index2. The European dividend-paying segment included 916 investable dividend payers as of January 31, 20143.
After applying a minimum-size threshold of $1 billion and a dividend coverage ratio greater than 1.0x, the following screens are applied:
• The Index includes the 300 companies with the best combined rank of growth and quality factors from this universe.
• Growth Ranking 50%: Derived from long-term earnings growth expectations, which ultimately encompass the estimated growth in operating earnings per share over the company’s next full business cycle, typically three to five years
• Quality Ranking 50%: Split evenly between three-year average return on assets (ROA) and three-year average return on equity (ROE)
A Focus on Growth and Quality Factors That Drive Dividend Growth
Quality Factors: In finance literature, return on equity is critically linked to dividend growth and intrinsic value of companies. The dividend discount model (DDM) for stock valuation states: The value of a stock = DPS (1) / (R-G)
Where: G = Growth rate in dividends = ROE x earnings retention (or 1 minus dividend payout ratio)
Simply stated, the growth of dividends is determined by the fraction of earnings that is put back into the firm and how profitable those earnings are in their subsequent use. A sustainable dividend growth rate is thus critically linked in finance theory to ROE. On a more practical level, Warren Buffett and Charlie Munger—aside from theorists, arguably the best stock pickers in recent history—discuss return on capital and quality as the critical factors they focus on: