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I have always been intrigued by dividend growth investing. The philosophy of the investing style makes absolute sense. The whole concept revolves around identifying companies that pay dividends and raise them over time. There are a number of key benefits of shortlisting the companies that meet these criteria. So, let’s look at the first principles of the investing style:

  1. These companies are profitable enough (after paying interest and taxes) that they can share some of the earnings with investors
  2. These organizations are confident in their ability to grow earnings over time as they have been continuing to raise their dividends
  3. With the virtue of compounding, one day these dividends should be enough to provide comfortable income in retirement

All this sounds amazing. So, considering all the merits, I thought why not start by looking at a solid dividend growth ETF, and luckily Vanguard has something perfect called Vanguard Dividend Appreciation ETF (VIG). By the way, if you are a fan of BlackRock/iShares, you can look at iShares Core Dividend Growth ETF (DGRO), and I like the acronym DGRO – you have to love these BlackRock folks, their marketing team seems to know what they are doing. Anyways, for now, I will stick with the big boring Vanguard one. So, would you guess how much assets Vanguard has under VIG alone? $58 B. I’m not kidding. It’s one of the largest ETFs in the world (my guess is the top 15). Here is a quick snapshot:

Source

So, broad exposure across 200+ companies with a median market cap of $140 B (read mega-caps mostly) with a PE of 27 and earnings growth rate of 9%. PE seems to be slightly higher, but you must pay up for quality. Plus, getting an earnings growth rate of 9% is a miracle in a world where getting a consistent 2% GDP growth is challenging. The current yield is only 1.7% but if these companies continue to increase it at the 9% rate, you would be looking at a 14.7% yield on cost in 25 years, which is phenomenal. Let’s also look at how it has performed compared to something like S&P 500.

Source

Here is a 10-year performance assuming you invested $10K in each. I find it surprising that VIG has underperformed SPY, even though it pretty much ticks all the right boxes. And this gap is not insignificant – it’s almost 17% over 10 years or 1.7% each year. I also looked at different periods e.g., 5-year, 3-year, and 1-year. For a 5-year and 3-year period, the performance is neck to neck, while over the last 12 months, SPY has again outperformed. All this to say, the dividend growth strategy gas struggled to consistently perform in line/outperform its broader market cousin a.k.a. S&P 500. Now your personal returns might be slightly higher or lower depending on the composition of the portfolio, but overall it kinds puts a damper.

Anyways, let’s take a deeper dive to understand this better. Remember, when we started the article, the investment style sounded like a ‘no-brainer’. So, I went ahead and started drilling down, and here is the sector breakdown:

VIG Sector Breakdown SPY Sector Breakdown

I notice one major difference between the two ETFs.

It’s the familiar term ‘Technology’, as the exposure to the sector differs widely between VIG (~13.6%) vs. SPY (~24.6%). The S&P 500 has hugely benefited from all the mega-cap technology stocks that have led the markets to the new highs, but most of those securities don’t have a dividend, so they are not part of the VIG and that is playing a big role in this underperformance. By the way, Facebook (FB) and Google (GOOGL) are hiding in the so-called ‘Communication Services’, so the exposure to technology stocks might be even lower than what you notice here. Now, knowing that fact, I’m assuming a lot of true dividend growth investors may also have refrained from exposing a significant portfolio of their portfolio to technology and maybe noticing the results of it.

The big question and the whole purpose of writing this article is to understand whether dividend growth investors should care about this at all. Or all these tech stocks are in a bubble; they will come crashing down and the best approach is to just stay away from it.

Let’s go back to the first principles of dividend growth investing – 1. Solid earnings/cash flow positive, 2. Confidence in the ability to grow earnings over time, 3. Ability to generate enough income to retire on.

So, what I’m going to do next is to figure out if there are any technology stocks that abide by these first principles – meaning proven organizations with a clear upward trajectory allowing you to get better returns. Again, we are not assessing Tesla (NASDAQ:TSLA) or Shopify (NYSE:SHOP) or Snowflake (NYSE:SNOW). So, please stick with me.

Let’s start by looking at the top holdings of VIG. As you may notice, these are some marquee names.

And here is a look at the SPY holdings:

So, keeping it simple, I will take the top 10 tech holdings from SPY (the ones not present in VIG) and compare them with the top 10 holdings of VIG on different metrics and see where they stand to answer the million-dollar question:

Are these tech stocks trading at those absurd valuations that everyone claims and shouldn’t be touched, or there is some merit in giving these a bit more thought?

If it’s almost a full-blown battle, why not make it a bit more formal by having two distinct teams (Orange and Green). And here is the lineup:

Okay. So, now, we have everything ready. Let’s see how these teams stack against each other on a simple XY chart with two dimensions – 1. Current EV/EBITDA and 2. EBITDA Growth Rate (3Y CAGR):

Prepared by Author using data from Seeking Alpha

Let me quickly orient you on the graph. Both the axes are clearly marked, and the black dotted line is similar to the concept of PEG of 2, though in this case, I have replaced PE (Price/Earnings) with EV/EBITDA and G (Earnings Growth) with EBITDA Growth. So, anything above the dotted line could be argued as undervalued because these companies’ EBITDA growth is high relative to their valuations and vice versa. Here are my quick observations:

  1. The Orange team a.k.a top dividend growth stocks are sort of trading at a much lower EV/EBITDA multiples, though their growth rates are also lower, so they are not necessarily bargains.
  2. Within the Green team a.k.a leading tech stocks, FB, GOOGL, and MA stand out as they are not so far along on the curve (not as expensive) compare to the fellow orange buddies. FB and GOOGL are especially looking good value.
  3. If someone is willing to pay a bit more, looking at companies that are further along the curve such as ADBE, AMZN, and NFLX is not a bad idea also.

Now I can go ahead and take a deeper dive into the fundamentals of each of the companies and how they are running their business and what may drive further growth, but that is not the core purpose of this high-level overview. I did provide a bit more detail in my technology write-up a few weeks back, and apart from that, there are tons of good materials on each of these companies.

Having said that, I am curious about how a similar chart may look like 3 years down the line. So here is one looking a bit more in the future based on estimated earnings growth:

Prepared by Author using data from Seeking Alpha

Same concept, but I couldn’t find easy access to 2022/23 EV/EBITDA, so I am using Price to Earnings. Not a big deal for this high-level comparison analysis. Here are my quick observations:

  1. Look at the distance between the orange and the green dots, the gap has significantly narrowed compared to the first graph, even though the green stocks are still exhibiting higher growth
  2. Now to compensate for that higher growth, the price of these green dots (in other words returns) may continue to increase
  3. Among the Green dots, FB, GOOGL, NFLX, and AMZN are especially looking quite a bargain considering the earnings potential, and that is followed by MA and PYPL
  4. I also highlighted the ones I own – UNH, MSFT, FB, GOOGL, AMZN, NFLX, MA – with the black periphery, and you may notice that almost all of them are on the undervalued side of the graph

Again, let’s go back to the first principles of dividend growth investing – 1. Solid earnings/cash flow positive, 2. Confidence in the ability to grow earnings over time, 3. Ability to generate enough income to retire on. All the companies highlighted in our green lineup (i.e., mega-cap tech stocks) meet the first two principles in spades. The only exception is NFLX that is not cash flow positive yet, but everyone else is generating tons of greens. The only principle that is still not met is the lack of a dividend, but as these companies mature, they would either start paying a dividend (think of AAPL) or through a combination of buybacks or investments in existing/new business generate solid earning that would more than cover the dividend.

Final Words

I am not hoping to convince you to completely change your investment philosophy overnight, but to nudge you towards stepping a bit out of your comfort zone by looking at some of these mature but non-dividend companies that may add significant alpha to your portfolio. I would advise you to start from here:

  1. Assess the portfolio performance against a broad benchmark such as S&P500 over different periods (3, 5, 10 years). If possible, get a bit more granular on what kind of investments are working and which ones are not. For example, I divide my portfolio into three categories – Consistent Compounders, High Flyers, and Special Situations and assess the performance of each category, so I know what kind of stocks are not performing. You can get a bit more details on my assessment and portfolio here.
  2. If you find that the overall returns are not as good and the lack of new-age tech is one of the reasons, consider the 80:20 rule. In other words, keep 80% of your investments in existing stocks / philosophies but plan to allocate 20% of the portfolio in the new economy stocks
  3. You can either approach it directly by picking individual stocks or look at any of the tech ETFs. I particularly like IGM because of its solid coverage compared to the other cheaper tech ETFs. You can read my perspective here on the IGM and other similar ETFs.

Before I close this article, I wanted to highlight the reason for writing this memo specifically for dividend growth investors. I’m noticing a wall on Seeking Alpha, and in general in the investing community. On the one side, we have investors who only believe in stocks with high dividend or dividend growth or deep value, but that has led them to completely ignore the change brought in by the new age economy (i.e., tech stocks). And it’s easy to become all folksy, and reference the dot-com bubble, and ignore all those ideas, this approach may prevent you from investing/benefiting from one of the most important engines of the 21st century. And yes, we are not in the dot-com era anymore. A lot has changed, and any of these companies I mentioned here and not in their infancy.

On the other side of the wall, there are folks who only believe in tech and are overextended in one sector. The last few years of exceptional performance has led them to believe that it’s the only place to be. From my perspective, they are missing out on a number of great opportunities in other sectors that may not only result in diversification but also provide solid returns or in other words uncorrelated returns, which is important. For the same reason, I continue to share my perspective on great ideas from other sectors and covered Healthcare and Industrials recently.

As always, I always look forward to receiving your comments and feedback and continue to share my 2-cents and add value to the community.

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Disclosure: I am/we are long NFLX, GOOGL, MA, FB, AMZN, UNH, MSFT, SHOP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.