WisdomTree

Equity

The Future of International Dividend Growth Indexes

by Jeremy Schwartz, Director of Research on June 18, 2013

We have recently introduced a new family of dividend growth-related Indexes focused on the U.S. equity markets. We are expanding this new “growth” methodology from the U.S. to the foreign markets with an Index screening change to an existing WisdomTree Index.

To create consistency across the globe in how WisdomTree identifies dividend payers with growth characteristics, the WisdomTree Global ex-U.S. Growth Index methodology applies the same growth-oriented stock selection rules as we introduced in the WisdomTree U.S. Dividend Growth Index. This new Index methodology takes effect as of the 2013 annual rebalance—or following the close of trading on June 21, 2013, with data based on an Index screening on May 31, 2013.

We believe WisdomTree’s new dividend growth Indexes stand out as the only indexes to screen for dividend growth characteristics or prospects instead of just for companies that have historically raised their dividends over a given period prior to determining eligibility for a dividend growth index. We believe that past dividend practices are not always indicators of future dividend growth potential. For example, within the WisdomTree Global ex-U.S. Dividend Index, WisdomTree’s most comprehensive Index of dividend payers outside the U.S., only two of the top 10 dividend payers did not decrease their dividend at least once in the past five years. Therefore, dividend growth screens based on consecutive years of payments would necessarily exclude 80% of the 10 largest payers.

Introducing the WisdomTree Global ex-U.S. Growth Index

The theme of U.S. dividend growth is certainly important, but the opportunity set of dividend payers is even larger beyond our borders. Below we outline our revised selection metrics and rationale for this new methodology focusing on dividend payers with growth characteristics:

Earnings Growth Expectations: This criterion is pretty simple: Firms expected to grow their earnings faster, all other things being equal, should have greater potential to increase their future dividends faster. We understand that these are only estimates, but we believe that, while there may be a lot of noise around a single company’s precise earnings growth, in aggregate the companies with higher growth expectations grow faster than those with lower expectations. And these companies have more capacity, in our opinion, to fund growing dividends.

Quality Factor Rankings: Our quality factor ranking is based on three-year historical averages for return on equity (ROE) and return on assets (ROA). We believe companies that generate greater profitability, controlling for any excessive use of leverage, should have a greater potential to increase their future dividends than firms demonstrating lower profitability metrics.

Warren Buffett often says in his annual letters that he looks for “businesses earning good returns on equity while employing little or no debt.” Since high leverage implies the use of debt, our use of a quality ranking that incorporates both ROE and ROA enables us to mitigate the use of leverage as a sole driver of what may superficially appear to be a high ROE figure. Two of our favorite quotes from Warren Buffett and his business partner on this “quality” factor:

        Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.         – Warren Buffett, Berkshire Hathaway Inc., Annual Report, 2008

        We’ve really made the money out of high quality businesses . . . If the business earns 6% on capital over 40         years and you hold it for that 40 years, you’re not going to make much different than a 6% return even if         you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years,         even if you pay an expensive looking price, you’ll end up with a fine result.
        – Charlie Munger at USC Business School in 1994

Key Characteristics of WisdomTree’s “Dividend Growth” Companies outside the U.S.

Now that we’ve discussed some of our rationale behind our Index constituent selection, let’s compare the characteristics of our approach to some other widely followed international equity indexes.

Index Characteristics as of May 31, 2013 Index Screening

Index Characteristics as of May 31, 2013 Index Screening

For definitions of terms and indexes, visit our Glossary.

• Higher Growth Expectations: The average long-term earnings growth estimates were over 7 percentage points higher for qualifiers to this Index than for non-qualifiers. They were also higher than the MSCI EAFE Index, the MSCI EAFE Growth Index and the MSCI AC World ex-US Index. Admittedly, these indexes are weighted by market capitalization and do not focus on dividend-paying stocks. However, we include them as widely followed international benchmarks outside the U.S., and it is a fact that the MSCI EAFE Growth Index does focus on companies that MSCI selects based on their above-average growth prospects relative to the universe defined by the broader EAFE Index.

• The ROE/Dividend Connection: The ROE for the qualifiers for the WT Global ex-U.S. Growth Index was almost twice as high as that of the MSCI EAFE Growth Index, the next highest. Additionally, the ROA was also basically double that of the MSCI EAFE Growth Index. This is a combination that we believe indicates that our selection criteria are focused on creating exposure to firms that are generating their profits efficiently.

• Lower Leverage: The qualifiers to the WT Global ex-U.S. Growth Index employ less leverage to operate their businesses than both the non-qualifiers and the broader equity market measures.

Conclusion

While there is no way to know what will happen in the future with certainty, we believe that our dividend growth methodology applies a framework to selecting stocks with growth characteristics. We have focused on variables that we believe are key drivers of dividend growth. Companies incorporated outside U.S. markets provide a widely ranging opportunity set of dividend payers, and we believe it makes sense to provide an option that attempts to select those best positioned for potential dividend growth.

Read our full research here.

Important Risks Related to this Article

Dividends are not guaranteed, and a company’s future ability to pay dividends may be limited. A company paying dividends may cease paying dividends at any time.

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