Predictive Power Lies in Understanding What You Own

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Is there anything predictable about the stock market? If so, how much power or truth does it hold? Do sophisticated models and strategies have a predictive edge? Even if you’re an investor with limited experience, the odds are at least one of these questions has piqued your interest at some point in your investing career.

In episode 43, Greg discusses predictability in ETF income and dividend growth. He examines various ETFs tracking the S&P 500, such as SPY, IVV, and VOO, highlighting discrepancies in their dividend growth rates from year to year. Greg emphasizes the importance of not making investment decisions based solely on headline numbers, as these may not tell the full story. The episode also explores the limitations of discounted cash flow models, touching on the challenges of long-term forecasts and the uncertainties of market competition. Ultimately, he advises investors to focus on understanding what they own and cautions against overly sophisticated financial models that may introduce more risk and uncertainty. 

00:00 Introduction to The Dividend Mailbox
00:46 Understanding ETF Predictability
01:46 Analyzing S&P 500 Dividend Growth
04:09 Comparing Different S&P 500 ETFs
10:49 Exploring the S&P 100 and Other Indexes
16:57 The Complexity of Enhanced Income ETFs
24:27 The Power and Pitfalls of Predictability
25:46 Diving into Discounted Cash Flow Models
31:13 The Terminal Value Trap
38:53 Conclusion and Final Thoughts

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Resources:

📅 Schedule a meeting: Financial Planning & Portfolio Management
📊 Getting into the weeds: DCM Investment Reports & Models 

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Disclaimer: Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risks involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.

Transcript

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[00:00:11] Greg Denewiler: This is Greg Denewiler, and you are listening to another epiSo,de of The Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks. When they grow over time, a funny thing happens, you create wealth.

Welcome to episode 43 of The Dividend Mailbox. And today, our key topic is predictability, and we're going to approach it from a few different angles. The first one, we're going to look at ETFs, several different ones, and look at some of what drives the predictability of an ETF income and why they might be different. We're going to dive into, okay, what does that mean? Should it mean anything? I think it's worth just being aware of what potentially can happen there. And then we're going to go into the discounted cashflow model, and here you really can get into a can of worms extremely fast. They're useful, but when you start getting into price, it can get extremely vague.

So, when you're the dividend mailbox, you get very excited when S&P Global comes out with the final number for the S&P 500 dividend for 2024, because that's basically what the center of the universe is for us. It's what we track. To say this over and over, we have a long-term goal of beating the S&P 500 dividend growth by 1% a year. Well, S&P Global issued the final dividend for 2024, it was $74.83. Now, the first thing that you need to know is this is not an ETF, this is the actual 500—I think there's 504, whatever it is in the S&P 500. These are the actual dividends that were paid out in cash. So, that is a growth rate of 6.4%. Well, lo and behold, if you listen to very many of these, that's the line. We haven't talked about the line for a while, but the line is basically the long-term growth of GDP for the last century, it's grown at roughly 6% per year, which includes inflation. And then we tie corporate earnings to that. It also has grown long-term by about 6%, but it is more volatile due to earnings and recessions. And then dividend growth is also roughly 6% per year, and it falls between corporate earnings and the smooth GDP line. So, the line is basically 6% long-term growth, and then we look at the S&P 500 index and what the dividend actually came in at, 6.4%—it was almost exactly on the line of what it grows long-term. 

Once again, I have to throw this out for those who think dividends are boring, that included an S&P 500 that was up about 25% for the year total return. So, not only did the dividend grow by 6%, but you had great total return. Well, where this is going is, okay, so, we were up 6.4%. I have a spreadsheet where I model a lot of different ETFs that we follow. Some of them we use to track dividend growth and we look for something that is more concentrated since the S&P has roughly a hundred companies that don't pay a dividend. A lot of them are relatively small. So, I'm updating the S&P 500 ETFs that track the index. I was kind of shocked, to be honest, with these exchange traded funds that all track the S&P 500. Your first assumption is, well, they should all be coming in almost exactly the same. Total return they have, but when you look at the actual dividends and the dividend growth rates, they start to have some material differences in them. The first question is, is that really something that we should pay attention to? And is it something you should make a decision on? 

So, I looked at SPY, which was one of the original big ones and it's managed by State Street, commonly referred to as spider—and it's dividend was up 7.7%. So, right away, I'm thinking, Hmm, okay. That's interesting. Why would that be up slightly more than the index itself? So, then I'm looking at the iShare S&P 500 fund, IVV. The dividend growth was up 10.9%. You know, the first thing that starts to come to mind is what in the world is going on here? These things are all set up to track the S&P 500, but you've got Some pretty significant differences in dividend growth rates here. So, finally, I looked at the Vanguard S&P 500 ETF, VOO, and it had grown by 5.4%, which was half of what the iShare fund had grown by. So, I'm thinking, what in the world is going on here? Well, the moral of this story that we're going to get to towards the end of it is: Be careful looking at headline numbers because they just hardly ever tell the whole story.

What I started to do is go back and look at—that was growth rate of the dividends for ‘24— so, I went back and looked in ‘23 what they had grown by. Well, the S&P 500, its dividend grew by 5.1%. You look at the SPDR, it grew by 3%. There, the higher growth rate for last year. It was sort of a reversion to the mean, because even though it lagged in ‘23, it made up most of the difference in 2024. If you look at IVV, it grew by 8%. It was actually better than the actual S&P 500 in and of itself. Vanguard, VOO, in 2023. It grew by 6.9%, So, it really is tracking pretty much from two years, pretty much exactly where it was supposed to be. Now, let's go back another year, and State Street, the SPDR grew by 11.7%, the S&P 500 grew by 10.8%, so, you're relatively close, about a percent difference. The Vanguard S&P 500 grew by 9.4%, and actually the iShare Fund grew by 11.5%. So, anyway, where this is going, if you just look at the headline number and you say “The iShare fund grew its dividend a little faster last year, I think I'll buy that one.” You probably are going to gain nothing by doing that. In fact, what you're going to do is maybe even lose a couple of bucks because it's going to revert to the mean. Here's kind of the proof of this. If you look at total return for the last three years of all these S&P 500 funds, they were all up a little over 32%, and the difference between all of them and the actual index was all at most about 20 basis points, which is 0.2% over a three year period on a combined total return. For all intents and purposes, they all were basically identical performers. But from year to year, the dividend growth rates were different. 

Well, I guess one question would be, why are they different? These ETFs pay out all their income, but since these dividends are coming in all year long, it's just a calendar period that potentially changes the numbers based on their timing, the cashflow to you is the same. It's the same basket of stocks and they all have for all intents and purposes, the same weighting. When you consider the timing of payments, slightly different expense ratios, it's going to skew the data a little bit, but over time, they all have virtually identical total returns. And the income that you're generating over a longer period of time is almost identical.

Expense ratios, all things equal, you want the cheapest one possible, but they're all pretty competitive and over time it's probably negligible and whatever you own is probably worth keeping because if it's not in an IRA it's going to cost you Something to move it. And I'm sure it's probably not worth it.

So, different dividend growth rates on paper might look like a tradable event short term, but when all said and done, there probably really isn't anything there. 

So, now we're going to take this out one step farther where maybe it starts to have a little bit more relevance. And that is, what if you own the OEF, which is the S&P 100. It's basically the 100 largest companies of the S&P 500. Well, there you've had a total return that over the last three years, because this index is a little different, it's heavier weighted on the top seven, actually is up 39%. So, it's outperformed the S&P 500 in the last three years by a little more than 7%. But then when you look at the dividend growth in 2024, it grew by about 12%. In ‘23, it only grew by 0.6%. In 2022, it grew by 14%. The three year growth rate is not that much different than the S&P 500. It's going to grow a little bit faster. You're starting from a lower yield because the top seven companies, which are all tech—they're all the usual names that you've heard over and over. On the OEF, they represent 45% of the S&P 100. If you look at the top 7 in the S&P 500, they're 30%. So, you know, there's quite a difference in weighting. And some of those top seven don't pay dividends, but some of them do Apple, Microsoft, and they're growing the dividend faster, but you've got a dividend yield of only 1% on the S&P 100, and the S&P 500 right now is around 1.2%. You've got potentially a little faster growth, but you're starting from a lower dividend. 

Just looking at income and dividend growth, you start to wonder: “Well, okay, you know, where's the best place to go?” The answer depends. It is a balancing act of yield, dividend growth, total return, and some of these indexes are going to be skewed more towards faster dividend growth. Usually that comes at the cost of you start a lower yield. Some of them have a lot more tech than others—the OEF especially is very tech concentrated. If you want a little bit more of a value tilt you go into ones that own very little tech. 

It comes back to don't let the numbers drive the bus. Let knowing what you own and why you own it be the main determining factor, because now let's go another step and there's another one that we track. It's the Wisdom Tree U. S. Large Cap Dividend Fund. The symbol on it is DLN. In there, the top companies, three of them are Microsoft, Apple, and Nvidia, but they only represent 10%. So, you're starting to move away from the tech waiting. If you look at the actual dividend yield on it right now, it's about 2%. So, you get a higher dividend. If you look back in May of 2023, the dividend was 2.7%. So, you've had a higher dividend and it started at a much higher rate, but if you look at dividend growth, here's a different story. The 2022 dividend growth rate was 16% and in ‘23, it was 2.9%. And last year, it was negative 4%. You know, you've got a little different makeup in the index, but you've got a weighting that that's not as heavy towards tech. If you don't want tech weighting, it becomes a potential better option and with the higher yield right now, if we don't get much of a market return this year, it may help you a little bit.

Well, going out another step, let's go to NOBL, which we've talked about. It's NOBL, it's the Dividend Aristocrat Fund. It's got very little tech in it. It's the companies that have grown their dividend for 25 years and they've grown them every year. If you look at that one, three years ago the dividend was actually down 6%. Last year, it was up 14% in ’23, and it grew by not quite 3% in 2024. So, the dividend overall is growing on a total return basis. It's underperformed recently because it doesn't have much tech in it. But from 2014, the dividend aristocrat fund has grown its dividend by 156%. The S&P 500 has grown its dividend by just short of 90%. Just as a point of reference, since we do mention our model portfolio semi-frequently on this podcast, I'm going to throw this number out. Over that same 2014 period to 2024, our income has grown by 170%. So, clearly in the long term, Noble has been a strong dividend growth candidate. If you want less tech exposure, then it quite likely is a positive going forward if tech struggles for a while. 

So, when you're considering ETFs, it is worthwhile to look at the dividend growth rate. I mean, it's definitely something that we do, but you have to be aware that there are several factors that come into timing, or what their actual composition is, as to why they work the way they do. So, just looking at face-value numbers doesn't tell the whole story, and if you don't know the whole story, you're quite likely going to get a surprise. That's kind of the point there.

So, now I'm going to move on to ironically, as we were putting the ideas together for this podcast, the Wall Street Journal had an article that came out on Wednesday the 8th of January. The article was titled: Your Fancy New ETF Might Be a Bit Too Fancy—and that's kind of the theme of this podcast. It goes through and talks about some of these new ETFs that are coming out where they're trying to enhance income or come out with a little different variation for marketing purposes. And they gave an example of an ETF that's designed to track the one-to-three-month treasury bill. They use some strategies to try to enhance that income to make it slightly more appealing than just owning a treasury bill. It's the Simplify Enhanced Income ETF, HIGH. It has an 8% plus yield currently. And this is much higher than the treasury market, almost double. That right there should be a little bit of a yellow flag as to what is going on here. 

Well, lo and behold, if you look at what this fund does from a simple observation and if you read the marketing piece from the company, it sounds pretty good. It “…Seeks to provide monthly income by selling short-dated put or call spreads on a variety of equity and fixed income instruments, which may include indices, ETFs, or individual securities. The fund is intended to be an alternative high-yield solution as it seeks to provide significant supplemental income to T bills, with a low correlation to traditional credit and duration exposures.” Which means, basically, they're trying to take the risk away from credit or longer maturities. And then it says “… A sophisticated option writing algorithm seeks to sell spreads that generate attractive risk-adjusted returns, while an additional layer of risk management helps manage tail risk associated with selling options.” You read all that and you think, “Hmm, okay, I don't know, this could be a good idea.” Well, in general, anything that incorporates the use of options is inherently more complex, and it involves more risk. The risk is going to come in one of two ways: either it's got more volatility, it's got potentially more risk on the downside, or it has the risk that you're not going to get the upside that you want or think you're going to get, because the options come with a cost to them. 

So, how good of an idea was it? Tbills earned about 4.5-5% last year. This fund came in at a return of plus 1.5%. So, apparently, their yield enhancement didn't enhance a whole lot. In fact, it went the other way. So, you start to look at this and figure out, well, okay, what happened and what do they own? Well, the first thing I should tell you is, they go through this big spiel about their risk management. If you look on December the 18th, in one day it lost 2.4%. And you think, “Hmm, okay, I wonder why that was.” Well, T bills on the 17th of December had a yield of 4.24%. On the 18th, they had a yield of 4.23%. On the 19th, They had a yield of 4.22%. Yields actually declined by 2 basis points, which is, for all intents and purposes, we're going to call nothing. However, if anything, the fund should have gone up by a fraction. If yields decline, then prices go up. Well, that doesn't explain what happened. 

Then let's look at the S&P 500—which should have nothing to do with the three month Treasury—on the 17th of December, the S&P closed at 6,050. On the 18th of December, it closed at 5,872. That was just a pretty significant hit in one day. And then it followed through on 12/19 down to 5,867 for the S&P 500 index. So, there you go. And you have to ask, why in the world are they even in this space? If you look at the portfolio, and I actually looked at the semi-annual report that ended December 31st of 2023. Here's the moral of the story: At this point, your fund had about $265 million in it, of which, they were short term treasury bills. But then you go through and look at what else is in there. This option-enhancing strategy they're using has generated $84,000 of income at the time of this annual report. That's the value of the option contracts they've either sold or purchased together. $84,000 is not a big number on $265 million, but when you're buying options, the risk of those things expiring is statistically pretty high. So, they sold some puts on the S&P 500, trying to pick up a little bit of income, but in order to generate that $84,000 of income, the notational value of those option contracts is $500 million. That means that the value that drives these auction contracts is based on a 500 million asset value, meaning if the market moves in a significant way, there's a lot of potential risk there. So, it doesn't mean it's bad, but there's no free lunch. You know, why not just buy a bond, a short-term treasury if you want yield, and that's what you get, and you know that's what you get. The problem with this stuff— you start getting into things that you just don't know in the end exactly what's going to happen. And there's embedded risk in this stuff that you don't always understand. These managers don't always understand it either. And they talk about managing the tail risk. Well, if you have the S&P 500, if you're short a bunch of puts and the market opens up down 1.5% in one day, you have no chance to get out. You get out on the first trade, which is down 1.5%, and that may not sound like much, but when you're tied to an asset that's a hundred times that, it starts to get a little ugly. 

This whole discussion comes into the sustainability of what you have and what you can expect in the long term. What we're looking at is what is the power of predictability and that's what we're trying to assess here. At what point is that threatened or is it really that much different from the funds that we own. Starting out buying one of these S&P 500 funds that earns an extra 2 or 3% in one year is not sustainable, it's going to revert back to the mean. It's the S&P 500, it's just a timing issue. As you go out in some of these other indexes, you're starting to get what they own underneath, and you have to understand that. If you can't predict, as they start getting into these enhanced strategies of exactly what they're going to do when you better be prepared for a surprise. The more variables you throw in there, you're really starting to give up predictability. This really goes all the way out to individual companies because the same concept holds true. The more you're just simply tied to that dividend line, the more predictability power you have.

So, now as we transition into more of the individual stock side, here we get into the concept of discounted cash flow. And I think this will tie in with what we've just talked about. It is used as a prediction tool for cash flow and the value of a company long-term. Just how much emphasis do you put on that and how accurate is it really?

Well, discounted cash flow has been around for centuries, so, it's not a new concept. For those of you who don't know, and for those of you who do know, sorry this will be pretty simplistic, but basically discounted cash flow is: A dollar today is worth more than a dollar tomorrow, and a dollar tomorrow is worth more than a dollar two tomorrows from now. So, the quick explanation of that is, if you have that dollar today, you can invest it. For simplicity, let's just say you earn 5%. So, one dollar earns 5 cents, and a year from now it's worth $1.05. Well, if you think you're going to get a dollar one year from now, what are you willing to pay for that right now? Well, you're probably not going to pay one dollar. If you do that, you earn nothing. If you go out and pay 95 cents for that dollar today, you get a return of 5% on your money. If you know you're going to get a dollar two years from now, you probably only want to pay 90 cents for it, because each year you get 5 cents. And now you're back up to the dollar, which is the same thing as if you just get a dollar today. 

What happens is people are willing to pay a lot of money for one dollar of earnings today for Nvidia because they think that one dollar three years from now could double, or maybe five years from now, would double, which means you're earning 15, 20, 30% on your money. So, what happens is the market normalizes all this. And the reason why Nvidia is so expensive compared to its dollar of earnings—the theory goes—you pay more for Nvidia, but you have to have growth to make it work that much. You can pay a lot less for something, like banks, insurance companies, and companies that are perceived to be much more cyclical, because they don't expect it to grow nearly as fast. So, the problem with these discounted cashflow models is, first of all, you're guesstimating a cashflow out at least five years. Sometimes they go out for 10 years, and then you use a terminal value, which we're going to get into, but you already have a problem right there. You're predicting what a cash flow is going to be three years, five years, six years from now. And then you throw in there, you have to discount it. Okay. By what number are you going to discount it by? And then you look at the risk factor—companies that are riskier usually have higher discount rates because you want to get compensated for the risk. And then you get into competition. Do they have moats? Are they going to issue shares (which changes the actual cash flow on a per share basis)? Are they actually earning their cost of capital? I mean, we can go on and on. And that's the point of why these things… they're useful, but this is not an exact science.

 You're basically saying: “I can predict the weather tomorrow.” Well, we know how well that goes. Usually it's somewhat close, and sometimes it's not, but it gives you a sense of, “Okay, tomorrow I probably need to wear a coat. Or when I leave for work in the morning, I probably need to put shorts on.” The weather may be different, but you use something as kind of a guesstimate on how you're going to spend the rest of the day. 

Discounted cash flow is what somebody thinks they're willing to pay for a stock. So, here's where this really gets hard. People tend to think— they come up with these fancy spreadsheets, and it's basically the difference between confidence and arrogance. Well, it's statistically been proven that analyst estimates are virtually always wrong, and these are the people that make a lot of money and a lot of them hold CFAs or MBAs or PhDs. Sometimes they're no better off than my favorite investor Ronald Read, who had a PhD in pumping gas. 

So, what we're going to talk about now is this article came out of a blog from the CFA Institute called The Terminal Value Trap. The problem that they go into is you're projecting a company's worth and you're going out past any period where you can have any effectiveness of forecasting. These terminal values, cashflow that's out five years, 10 years out from now, you're putting a value on that—what it's going to grow at into perpetuity. A value of cash flows that goes out for decades, and you're coming up with one number of what those multiple decades actually add up to. They're always way off, and to make things worse, the terminal value is where a significant part of the value comes from. It's what gets spit out as to what these companies are worth according to these models on that particular day.

This author made an interesting observation. The average holding period now for a stock is three months. If you go back to the 1950s, it was eight years. The average investor is holding a stock for three months, and in that period of time, you can come up with all the terminal value predictions you want, but in a three-month period, it's all perception. It's all market momentum. It's how the mood shifts and it has nothing to do with how that cash flow plays out over time. You've gotten into an environment where people use these terminal values, use these discounted cash flow models, and come up with these fancy estimates of what a stock or what a company is worth, and they have no intentions of actually finding out whether they're going to realize that cashflow or not. 

One of the examples that the author used was BlackBerry. I mean, there are just several of these. BlackBerry's claim to fame was getting texting and emails on your phone. I mean, you weren't anybody unless you were carrying a BlackBerry phone. In 2006, they had 50% of the smartphone market. If you looked at a discounted cash flow model, they came up with a value in 2007 of BlackBerry should be worth $80 billion. Well, there was one minor problem. In 2007, there was this phone that came out, you may have heard of it, it's called the iPhone. It had just hit the market—the marketplace really had no idea of how successful that was going to be yet. Well, it didn't take that long because, in four years, BlackBerry had lost 96% of its value. So, there you have a very attractive terminal value that just proved to be totally illusionary based on competition that really came out of nowhere.

This happens a lot. In fact, the estimates are that 10% of the companies in the United States go bankrupt each year, and if you take that out for a decade, that means basically 35% of the companies in the US go bankrupt. Now I will tell you, I think that is skewed towards smaller companies. It's not necessarily as relevant to the big S&P 500 list, but even there, we've talked about this in the past, you look at decade to decade, the 10 top valued companies that list changes virtually every decade, and it's extremely hard to stay on it. So, it's just another illustration of how this whole discounted cashflow and terminal value concept is so hard. 

Well, you may be thinking: “Okay, what are you trying to tell me? It's worthless?” Actually, this is the part that I really thought was good about this. The author's comment was: “Use it as a guided principle and not a blueprint.” For stocks, if they're in especially fast-evolving sectors, (i.e. technology), you just have to realize that the discount cashflow model— there's a point where it just becomes purely academic. There is nobody on the entire planet that can predict what NVIDIA is going to earn five years from now and they're probably not even going to be close. They're either going to be too low or they're going to be too high. Both of those change what you should be paying for NVIDIA depending on what your outlook is.

The point of this is, try to look at cash flow as, okay, what am I projecting here? Is it relatively conservative? Am I allowing for competition? Am I allowing for some version of reversion to the mean? Just ask one simple question: Does everything have to go right for this company to be worth what I'm paying for it today?

One of the things that the author gets into is, according to his analysis, really a five-year hold was kind of the sweet spot. We use 10, but it's the same concept. It's time for earnings to kind of smooth out, volatility to smooth out, and fundamentals to work. It's where the longer you hold just the market in general, the higher your likelihood of earning a positive return. So, when it comes to predictability, performance, total performance, financial results, and price, these things are impossible to predict from day to day. You can use estimates as guides and you should use them as guides. But what is very predictable is the dividends that are hitting your account, and for the simple reason that companies don't like to change them unless they're really forced to.

Back to our model portfolio, at the beginning of each year, we look at what we think the income will be for that year, and we've gone back and looked at how close we were to predicting the income. In the past four years, we've been off by only about 3.5%. It was actually better, it came in higher. Now there's an exception in here, in 2023, we were actually off by 11%, but again, we were low. Money market funds started to yield a lot more, so, we actually erred on the low side and our income came in higher. Then if you take this to the middle of the year, we have been, at worst, off by 1.5%. Again, that was in 2023, most of the time it's less than 1%. Now, does that mean we're smoking the S&P 500? No. What it means is we're managing the income of the portfolio, growing it over time, and ultimately it is extremely predictable. 

So, as we wrap this up, there's one point that I hope you take away from this, if nothing else. All numbers have stories behind them. You really shouldn't take anything face value. You should look behind everything you're considering buying or what you own. Or if you're going to invest with somebody, have a really good feel for what they're doing because the last thing you want is a huge surprise. When you create a story, and you attach a number to it, and you're able to build a very compelling story that makes your number seem like it's a very accurate number, what you're doing is you're trying to create a following, and you're trying to get looks. In the financial world, the bigger following you get, the more you can monetize that. You have to be really careful, it can become a real conflict of interest to what you're trying to achieve and what your expectation is. So, the more sophisticated a model is, the more complicated your equation is, the more chances of it being wrong. Simplicity, as Da Vinci says: “Simplicity is the ultimate sophistication.”

If you enjoyed today's podcast, please leave us a review and subscribe. If you would like more information regarding dividend growth or our investment strategy, please visit growmydollar.com. There you will find previous episodes and also our monthly newsletter. If you have any questions or anything to add to today's episode, please email ethan@growmydollar.com. Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.