Domestic equities have rebounded dramatically from their lows of March 9, 2009. From its close on that date through the end of 2010, the total return on the Russell 1000 has been 96.73%, or 45.22% annually. The total return on the Russell 2000 has been 134.03%, for an annualized gain of 59.81%. Initial rallies from bear market lows are often characterized as “junk” rallies, led by companies with weak fundamentals, poor earnings quality, and weak management. Many of these stocks are in the most economically sensitive sectors and trading for less than $10/share. More often than not, small and mid cap companies outperform large and mega cap issues during such rallies. The initial rallies from the market lows in 2002 and 2009 exhibited these characteristics.
Standard and Poor’s quality rankings are a function of the variability in a company’s earnings and dividend growth over the prior 10 years. High quality stocks dramatically outperformed low quality issues early in the bear market. However, they lagged dramatically from the fall of Lehman Brothers through the end of last year (see “High Quality Stocks Positioned for a Comeback”, August 2010). Given that dividend growth is one of the metrics S&P uses to define quality, it is no surprise that the average dividend paying stock has underperformed the average non-dividend payer over the last two years, dramatically so in 2009 (Charts 1 & 2). So, are dividend paying stocks ripe for outperformance?
To answer this question, we reviewed the performance of dividend and non-dividend paying stocks in the Russell 1000 and Russell 2000 indices from 1990 through 2010. To eliminate the impact of capitalization, we equal-weighted the performance, providing an indication of the performance of the average dividend and non-dividend paying stock within the benchmarks. This was especially important within the Russell 1000, which includes mid, large, and mega cap issues and in which performance was negatively correlated to market cap over the last two years. Despite lagging dramatically over the last two years, dividend payers have outperformed non-dividend paying stocks over the last 21 years. Many may be surprised to learn that the performance differential is far greater in small cap segment of the market than in the large cap space (Chart 3). As an aside, evidence of the superior performance of dividend payers in the small cap market was a factor in our decision to invest our small cap allocations utilizing Denver Investment Advisers’ Westcore Small Cap Value Fund, which is a dividend only strategy.
Dividend paying stocks have outperformed non-dividend payers in 11 of the last 21 years in the Russell 1000 and 13 of the last 21 in the Russell 2000. The average return (i.e. the simple average, not the annualized return) is actually higher for non-dividend payers in the Russell 1000 due to outliers in the return differential during the equity bubble in 1999 and during the “junk” rallies of 2003 and 2009. However, the median return for dividend payers in the large cap benchmark is 202bps larger than that of the non-dividend payers. In the small cap benchmark, the median return on dividend payers is nearly 50% greater than that of non-dividend payers. Additionally, the standard deviation of non-dividend paying stocks has been approximately 150% of that of dividend paying stocks in both benchmarks (Table 1).
Admittedly, 21 data points is a small sample on which to construct a standard deviation. A far more robust figure would have been derived had we had access to monthly data. Yet it remains reasonable to suggest that dividend paying stocks have generated their returns with far less volatility than non-dividend payers.
From 1990 through 2010 there has been only one occasion in which non-dividend paying stocks in the Russell 1000 outperformed dividend payers over three consecutive calendar years (there have been two such periods in which dividend payers outperformed). That occurred from 1993 through 1995, when the average performance differential between the two was 162bps and that was largely due to 338bps of outperformance in 1995. Within the Russell 2000, there have been three separate occasions in which dividend payers have outperformed over three consecutive years, but there has not been such an occasion for non-dividend payers over the last 21 years.
One should expect non-dividend paying stocks to outperform dramatically in the initial rally from bear market lows as they did in 2009. While they outperformed once again in 2010, the magnitude of that outperformance was far less dramatic. As the market and economy continue to recover, earnings growth and margin expansion will moderate. Market leadership is likely to transition to companies that are less levered to the economic cycle, possess greater consistency of earnings growth, and pay dividends. Yet while the leadership of non-dividend payers is clearly long-in-the-tooth, it is likely to continue through the first half of 2011 if not the entire year. The combination of QEII and the fiscal stimulus announced in the 4th quarter is likely to result in the performance typical of the third quarter of the presidential cycle. This tends to favor high beta, higher valuation, and lower quality stocks. Yet over the next six to nine months we fully expect market leadership to begin a transition to higher quality, dividend paying stocks and that such stocks are likely to outperform lower quality non-dividend paying stocks by a significant margin over the ensuing two to three years.