Screening Dividend Stocks for Future Growth (Part I)

Karin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you have read any of my previous dividend-focused articles, you know that not only do I consider absolute yield as a factor for my selection of a company, but I also consider the number of years that the company has been paying and raising its dividend, and its five-year Dividend Growth Rate (DGR). Thus, I look at the company’s commitment to growing its dividend as well as its actual payout rate.

I recently read an article about a brand new WisdomTree Dividend ETF that is designed to select dividend-paying companies that also exhibit certain “fundamental factors” that indicate growing dividends in the future.

The managers of WisdomTree US Dividend Growth Fund (DGRW) say they will be looking at forward earnings projections and trailing three-year returns on equity and assets in order to determine which companies are good candidates for future dividend increases. “Rather than relying on historical records of dividend increases, DGRW uses real-time growth and quality metrics focused on companies who are growing their dividends.”

The fund will own the 300 highest-scoring companies when it runs its screens out of a universe of 1,300 stocks. With a projected 0.28% expense ratio and a goal of 2.25% yield, the fund’s investors will potentially net 2% on their investments.

Dividend growth or current dividend yield?

The argument here is that one should focus on the potential for the dividend to grow as opposed to the actual current yield. And according to this theory, the best opportunities for dividend growth in the future also seem to entail a low dividend yield currently.

One thing that the fund’s management notes is that the fund’s success or failure cannot be judged on short-term results, but that a longer period of time must be considered before the methodology reveals its potential for outperformance.

I disagree with this thesis. In my analysis, I also focus extensively on whether or not I believe a company will be able to grow its dividend over the long-term. I use different metrics than the WisdomTree managers in order to determine whether or not I believe a company is dedicated to a dividend growth strategy.

And I don’t think that an investor has to sacrifice current yield in order to secure the potential for future dividend growth. In fact, I’m out to prove exactly that with my Perfect Dividend Portfolio. It’s definitely possible to achieve high current yield (higher than 3%) along with excellent potential for future dividend growth.

Why historical dividend metrics matter

I have a couple of problems with the way that WisdomTree is promoting this new fund.

First of all, they are disparaging historical dividend metrics, saying that such information is backward-looking. Of course it is. And although past performance is not a prediction of future performance, in the case of dividend-paying and dividend-raising, it tends to be an excellent indicator of future performance. Companies that have built up a reputation for a significant time period of raising dividends are reluctant to break that streak.

And all of the companies that I choose have maintained their dividend-raising streaks for more than 10 years, which means they made it safely through the worst recession of modern times without cutting or freezing their dividends. If they succeeded there, chances are very good that they will not have to cut or freeze in the future, barring a true financial disaster.

To be sure, I am looking at each company’s future earnings growth projections, as well as their historical dividend metrics. A company can’t keep raising its dividend if its earnings don’t grow.

My second issue with the WisdomTree fund is this statement, which was in an article about the new fund: “But if the fund's methodology does track dividend growers in the manner WisdomTree expects then any expectation for outperformance would be over longer periods of time.”

Frankly, I don’t believe that investors are willing to wait years to find out if WisdomTree’s methodology is better than that of any other dividend fund. I know that dividend investors, as a whole, tend to focus more on longer-term versus shorter-term metrics, but this fund will have to prove itself in the short term in order to attract investors, and I have serious doubts about what exactly it will be proving.

At 300 companies and a yield of only 2%, the WisdomTree fund looks suspiciously like the S&P 500 to me. I am betting that its performance will be similar over the next three to five years. Maybe in ten or twenty years, its stock-selecting methodology will be proven superior to another dividend ETF’s methodology, but it may be difficult to persuade investors to stick around for that long.

WisdomTree’s holdings

The fund is more heavily skewed toward technology than most dividend funds, with 20% of the weight in that sector. Industrials, consumer discretionary, and consumer staples each account for 19%, with the remainder of the weight comprised of health care, financials, materials, and energy. There are currently no companies in the telecom or utilities sectors, presumably because they do not meet the fund’s criteria.

The top five holdings include Apple, Microsoft, Procter & Gamble, Wal-Mart, and Coca-Cola. I’ve taken a look at most of these companies lately, so I’ll summarize my findings.

Apple (NASDAQ: AAPL): Apple has only been paying a dividend for one year, and the company did increase it after only three payments, by 15%, from $2.65 to $3.05 per quarter. Its massive cash hoard easily supports a continued payment, despite the fact that most of that money resides overseas, and that Apple will actually be using borrowed money to pay its dividends and support its stock buyback program. (This is a smart business decision, if not considered especially “patriotic” in that it is less expensive to borrow money than it is to pay the taxes on the repatriated funds.)

The payout ratio of the dividends is a minuscule 19% of earnings, and its 2.8% current yield is attractive for many investors, but too low for me. If they continue to raise the dividend aggressively, it may be something for me to consider in a few years.

Microsoft (NASDAQ: MSFT): Microsoft is also in the “less than 10 years” category, but it’s actually looking quite good. Another year or two of raising, and if it keeps its DGR above 10% (currently at 15.6%) and its projected earnings growth rate high (currently 8.8%), then it might be a consideration. Unfortunately, it does yield less than 3%, and I aim for higher than that, but it is definitely worth watching.

Procter & Gamble (NYSE: PG): A reliable company that has raised its dividend for 59 years, and it can safely be expected to continue to do so. With 8% estimated earnings growth over the next five years and a five-year Dividend Growth Rate of 9.6%, this indicates a healthy commitment to an annual increase in the dividend. Procter & Gamble is a serious contender.

Coca-Cola (NYSE: KO): Coca-Cola’s yield is lower than I like, at 2.7% (but still higher than the S&P 500’s yield), but it has been raising dividends for 59 years, so it’s a pretty safe bet that it will continue to do so. Coca-Cola is projected to grow earnings at nearly 9% annually over the next five years, the dividend has been growing at an average rate of 8.1% over the last five years, and the payout ratio is a decent 67%.

Wal-Mart (NYSE: WMT): I haven’t taken a look at Wal-Mart in a while, so I’ll do so now. Wal-Mart yields 2.5% and has been paying and raising dividends for 37 years. Despite challenges to the retail marketplace, Wal-Mart has been holding its own as the king of retail. Wal-Mart’s earnings are projected to grow nearly 10% per year over the next five years, its five-year DGR is a very healthy 13.7%, its total 12-month return is 19%, and its PE is reasonable at 15. All in all, I like Wal-Mart, except for the low yield.

I think with these sorts of holdings, and with the strategy they are following, the fund will quite closely mimic the S&P 500 in both price appreciation and dividend yield. I bet it’s hard to distinguish yourself when you are holding 300 companies. I’ll be watching it to see if this is true.

In the meantime, be sure to read Part Two to find out what I recommend instead of the WisdomTree holdings.

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Karin Hernandez has no position in any stocks mentioned. The Motley Fool recommends Apple, Coca-Cola, and Procter & Gamble. The Motley Fool owns shares of Apple and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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