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The lure of growth

Across sectors, there is little correlation between dividend growth and share price growth. Which means growth investing is tricky.
April 23, 2020

Many of you want to invest for growth. This is not as easy as it seems. 

We already know this about international equity markets. Jay Ritter at the University of Florida and economists at MSCI have shown that, across countries, there is no link between longer-term GDP growth and equity returns. In the past 10 years, for example, China has grown strongly despite its recent slowdown. But its stock market has performed worse than that of the Netherlands, whose economy has grown only slowly.

There are good reasons for this. Economic growth need not benefit listed companies. Its fruits can instead go to unlisted firms, foreign ones, ones that have yet to start up – or even, sometimes, to workers. And of course, even if GDP growth is associated with profits growth for listed companies, this fact should be discounted by markets in advance. If it is, there’ll be no contemporaneous correlation between growth and equity returns.

Which is indeed the case if we look across countries.

But what if we look across sectors of the same market? Is this still true?

Yes – to a large extent. My chart plots dividend growth and share price changes in the past 10 years for the 25 main FTSE sectors. There is a positive correlation between the two, but only because IT stocks have delivered great dividend growth and relatively good share price performance. Otherwise, there’s no link. Transport and pharmaceuticals, for example, have seen similar dividend growth but one has been the best performing sector in the past 10 years and the other the worst. And food retailers, which have seen dividends fall, have actually done better than most sectors.

You might object that the market’s slump in the past two months means that this period is unusual. I’m not so sure: unexpected bear markets and recessions are part of investment reality. But let’s consider the previous 10 years, from March 2000 to March 2010. Then, there was a good correlation between dividend growth and share price growth – of 0.54 across our 25 sectors. Food retailers, telecoms and utilities all saw nice rises in both dividends and prices, while IT, general retailers and support services saw falls in both.

If we wind back to the previous 10 years, however, we again get a zero correlation. For example, food retailers and tobacco saw above-average dividend growth but below-average price gains, while IT share prices soared, but dividends were weak, as companies financed expansion rather than payouts to shareholders.

The message, then, is tolerably clear – as much as it can be in noisy data. We cannot rely on dividend growth translating into share price growth. Even if we could predict future dividends – which we cannot – we wouldn’t greatly increase our chances of picking the right sectors to buy.

There’s a simple reason for this. Equity markets are sometimes efficient, so they discount dividend growth in advance. Worse still, they sometimes over-discount it. Ten years ago, for example, miners were on a low yield in anticipation of high growth. Their good actual dividend growth did not therefore translate into share price growth simply because it was discounted in advance. Conversely, pharmaceuticals were on a high yield because investors feared weak growth. As this materialised, therefore, it did no damage to prices because it was in the price long ago.

You might wonder: if we shouldn’t go for growth should we instead simply seek income instead?

Not necessarily. There’s a danger here too. A high yield can be a sign of higher risk – in particular the risk of recession. At the start of this year, for example, housebuilders and smaller oil stocks were on good yields. But they’ve been clobbered by the recession. Equally, mortgage lenders were on great yields in 2007 – but some of them subsequently collapsed.

Indeed, even over longer periods the link between yields and subsequent price changes is weak. In the past 10 years it has been almost zero across our main 25 FTSE sectors. Ten years ago, oil and transport stocks were on above-average yields for example, but they subsequently underperformed the market.

For me, all this amounts to a case for tracker funds. The reason to hold these is not that the market is efficient. It is instead that we cannot rely on it being inefficient, and that we cannot confidently identify its particular inefficiencies. Tracker funds economise on our thinking and so protect us from being led expensively astray.