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ETF Specialist

This Quality Dividend-Growth ETF Looks to the Future

This strategy effectively targets firms that should have the capacity to raise their dividends in the future.

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Dividend growth is nice if you're along for the ride, but it can be challenging to identify future dividend-growth leaders. A record of consistent dividend growth is often a good sign, but requiring a lengthy dividend-growth record can preclude investments in firms that recently started paying dividends or whose fundamentals have improved. WisdomTree U.S. Quality Dividend Growth ETF (DGRW) uses forward-looking information to target stocks that can grow their dividends significantly in the future. 

Morningstar Take 
This exchange-traded fund favors highly profitable stocks with durable competitive advantages that should have the capacity to raise their dividends and generate attractive returns over time. But it ignores firms' records of past dividend growth, which reflects managers' willingness to raise their dividends and the stability of the underlying businesses. As a result, DGRW has tended to exhibit slightly greater volatility than Vanguard Dividend Appreciation ETF (VIG). It also charges a higher fee of 0.28%. It warrants a Morningstar Analyst Rating of Bronze. 

This strategy targets 300 dividend-paying stocks with high returns on assets and returns on equity over the past three years and a forecast for high earnings growth. Most stocks that make the cut, like Procter & Gamble (PG), Microsoft (MSFT), and Apple (AAPL), are highly profitable and enjoy durable competitive advantages. However, many of these firms would not pass a demanding screen for past dividend growth, similar to the one employed by VIG. There are pros and cons to each approach. A record of dividend growth is evidence that a firm's managers are committed to a shareholder-friendly payout policy and is a sign of stability. But restricting stock selection to this criterion excludes many emerging dividend payers and ignores forward-looking information about the sustainability of dividend growth. 

Despite its growth focus, the strategy's dividend-weighting approach keeps it in the large-blend Morningstar Category. It weights each stock based on the value of dividends it is expected to pay over the next year. This causes the fund to overweight stocks that are cheap relative to their peers based on dividends and to double down on stocks as they become cheaper, when it rebalances. Similarly, it trims positions as they become more expensive. 

So far, the fund's approach has worked well. From its inception in May 2013 through October 2019, it beat the Russell 1000 Index by 34 basis points annually, with comparable volatility. This was partially attributable to favorable industrials sector exposure. 

Fundamental View 
This strategy emphasizes profitability and long-term growth over high dividend yields. Its dividend yield is usually only slightly higher than the Russell 1000 Index's. But there is a bigger difference in the average profitability of their constituents, measured by return on invested capital. Consistent with its tilt toward more-profitable firms, the portfolio also has greater exposure to stocks with durable competitive advantages based on Morningstar Economic Moat Ratings.

The strategy's dual focus on return on assets and return on equity offers a more holistic picture of each firm's profitability. While firms can boost return on equity through financial leverage (debt financing), return on assets strips out this effect and offers a cleaner measure of operating efficiency. 

These selection criteria, together with expected earnings growth, influence the portfolio's sector weightings. For example, utilities generally do not have high returns on capital, as their returns are often regulated. Given the sector's muted profitability and low growth rates, the fund currently has no exposure to utilities stocks. It also has less exposure to real estate and financial-services stocks than the Russell 1000 Index because they tend to have high leverage, which can hurt returns on assets, and low expected growth. It currently has greater exposure to consumer staples and industrials stocks than the Russell 1000 Index. 

Because the fund's holdings tend to enjoy profitable growth, they should have the capacity to increase their dividends at a healthy clip over time. However, the expected earnings rate of the fund's holdings often isn't significantly different from the Russell 1000 Index's, based on consensus estimates presented in Morningstar Direct.

More importantly, the link between expected earnings growth and actual dividend growth is not ironclad. Stocks can, and often do, miss earnings expectations. While earnings-growth forecasts are generally directionally correct, realized earnings growth does not necessarily translate into dividend growth. A stock with strong earnings growth may elect to reinvest those earnings rather than increase dividends, which can be prudent when returns on capital are high. Because the fund does not screen for stocks with a record of dividend growth, as some of its peers do, it ignores potentially useful information about managers' willingness to raise their dividends. 

Dividend-payout rates are a good indicator of dividend safety and growth potential. Lower payout rates usually indicate that a firm is reinvesting a larger portion of its earnings in the business to fuel growth. (This may not be the case if the firm has a large share-buyback program.) They also suggest that the firm has a larger cushion to protect its dividend payments if its earnings dry up. At the end of September 2019, the average payout rate of the portfolio's holdings was 0.44, a bit higher than the corresponding figure for the Russell 1000 Index (0.36), based on forward-looking data. 

Alternatives 
Gold-rated VIG (0.06% expense ratio) takes a different approach but offers similar exposure to highly profitable stocks. It targets stocks that have raised their dividends in each of the past 10 years and weights its holdings by market cap. Firms that pull off that feat tend to have shareholder-friendly management, lucrative businesses, and strong competitive advantages. 

Schwab U.S. Dividend Equity ETF (SCHD) offers exposure to quality dividend payers for a much lower fee (0.06% expense ratio). It targets stocks with high return on equity, high cash flow/debt, high dividend yields, and strong dividend growth over the past five years. This tilts the portfolio toward value and wide-moat stocks. The fund carries a Silver rating.

 

 

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Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.