At WisdomTree, we spend a lot of time researching and writing about trends in fundamentals, such as dividends or earnings, and one topic that always attracts a lot of interest is dividend growth. With regard to U.S. markets, we have continually made the case that above-average dividend growth has been supporting above-average market returns over the past few years. Also, we believe that the increase in net share buybacks could potentially lock in above-average dividend growth going forward. We typically make these points with regard to the broad U.S. equity markets, but today I would like to hone in on mid-cap equities.
The Dividend Decomposition Model
Equity fundamentals such as dividends or earnings are important characteristics that can influence returns over the long run. When considering dividends, one way to frame returns for an index is a mathematical decomposition of the total returns over any period into two sources:
+ Price Returns:
• Valuation Changes
+ Average Dividend Reinvestment Rate (Average Dividend Yields )
For dividends, higher dividend growth rates or higher dividend reinvestment rates (average dividend yields) typically support higher total returns. For valuation changes, if stock valuations rise, the return from valuation changes will be positive and increase total returns. Valuations in this context can be seen as rising price-to-dividend (P/D) ratios or declining dividend yields. If stock valuations fall (falling P/D ratios or rising dividend yields), the return from valuation changes will be negative and hurt total returns.
Five-Year Dividend Return Decomposition
• Dividend Growth Rates Were Impressive, with all indexes above displaying double-digit dividend growth. At 19%, the WisdomTree MidCap Earnings Index (WTMEI) recorded the highest dividend growth over the period, so it is no surprise that is also had the highest total return. One reason we believe WTMEI was able to generate such high dividend growth is the fact that the Index screens and weights eligible companies by profitability on an annual basis. In finance theory, the sustainable dividend growth rate is considered to be a combination of a company’s profitability and its reinvestment rate (or 1 minus its payout ratio). Therefore, we believe WTMEI’s focus on profitability and high reinvestment rate (low dividend yield) over the period led to higher dividend growth.