Part Four in a series on Story Capital's favorite investment strategy.
Today we are examining the 5-year historic performance of one of our favorite strategies: Dividend Growth. More importantly, we are going to look at comparative performance averages across 4 major market capitalizations relative to their respective broad market indexes at four time periods: Q1 2020, 1-year, 3-years, and 5-years.
Query: Can the Dividend Growth Strategy consistently deliver better performance than its index peers in the worst of times?
Any chart of rolling 5-year performance for the broad market indexes ending 3/31/2020 looks ugly – more like the M&M logo than the Nike swoosh! From Q4 of 2015 through 2017, the market was generally up; 2018 hit an unexpected speed bump in Q4 retreating about -16% for the year; we had an awesome rebound in 2019 and then “BAM!” The market was hit by the COVID-19 freight train in Q1/2020 that smacked the market down again about -25% and knocked us all the way back to October 2017 market prices!
For context, an index is defined as a measure of the stock market, or a smaller subset of the market, that helps investors compare current price levels with past prices to calculate market performance or relative market performance between subsets. Therefore, an index can be an excellent comparison tool. That is exactly how we will use indexes here: we are going to compare the average performance of four different company sizes of the Dividend Growth strategy to the average performance of the corresponding indexes.
We will only report the net difference between them or what is called “relative performance” for the sake of simplicity. By equal weight, we will average the performance of the following size categories (also called “market capitalizations”) across four time periods:
- Small Cap (Russell 2000)
- Small-to-Medium Cap (Russell 2500)
- Medium or Mid Cap (Russell Mid Cap)
- Large Cap (Russell 1,000 Value)
By comparing the average performance of the Dividend Growth strategy to the average performance of their indexes, we gain a solid perspective of how Dividend Growth performs relative to the broad market. In doing so, we answer the above query and we will gain enough perspective to answer the following related question: Does the Dividend Growth strategy deliver enough additional performance above the index to justify the slightly higher cost required to manage the strategy instead of simply indexing the market? The simple math:
Average Dividend Growth performance – Average Index performance
= Alpha, or relative performance across all four company sizes
A positive outcome means the Dividend Growth strategy delivers more performance. A negative outcome means index investing would have been a better investment route.
652 basis points
1,057 basis points
679 basis points
486 basis points
Friends, it is an enlightening discovery to learn that the Dividend Growth strategy consistently delivers better performance across all time periods and company sizes than the average of their market indexes in the worst of times, ending 3/31/20! Answering our second question, we believe the Dividend Growth strategy outperforms the index management strategy with sufficient additional margin to cover the slightly higher cost of using an active management strategy in our client portfolios.
Sustainable Alpha outside of a Hedge Fund? Hmm…that is another question for another day!
For those with inquiring minds, here is another statistic that provides insight on our conclusions above:
The 5-year Up Capture of Dividend Growth averages 103% of its index peers. In other words, if the index returns a positive +10%, its Dividend Growth counterpart will likely return +10.3% on average. If Dividend Growth were a car, it would travel slightly FASTER than its peers. By contrast, over rough and dangerous roads, the Dividend Growth powered car experiences only 76% of the 5-year Down Capture of its index peers. So, if the index returns are down -10%, Dividend Growth would likely lose only -7.6% on average. To coin an old phrase, it appears that dividend growth “wins by not losing as much in hard times!” Dividend Growth appears to be a wonderful “defensive equity strategy” that pays dividends!
Slightly faster in good times, safer in scary times. That is how ALPHA is maintained!
Further, while the Dividend Growth engine’s average dividend yield is 2.2%, only slightly above the S&P’s dividend yield of 2%, the rate of growth of the Dividend Growth strategy is more apt to be two to three times the rate of dividend growth in the S&P. For documentation of this statement, please see our Coke analysis in our Dividend Growth Part 2 blog post.
In Story Capital’s two main markets, Dividend Growth is an excellent complement to (1) an otherwise highly concentrated large-cap portfolio for executives with equity compensation and (2) a wonderful tool for multi-generational families interested in creating a legacy of long-term income growth while protecting the family’s capital base. In either scenario, and a multitude of others, the Dividend Growth strategy provides client families with compounding tax-advantaged cash flow through dividends and defensive growth of the underlying securities.
For clients who seek or wish to focus more on current income yield, we can customize the design of the Dividend Growth strategy to focus more on current yield and a bit less on long-term growth.