Fully franked dividends vs US Exceptionalism

“US Exceptionalism” is the idea that America stands apart — distinctive, unique, even exemplary among nations[1]. Coined nearly 200 years ago by French historian Alexis de Tocqueville after his 1831 visit, the phrase has taken on new life today with the term often shorthand for the remarkable strength of the US sharemarket and US dollar. Both have delivered powerful returns over the past decade.

Australian investors benefit from a strong US dollar, as this enhances offshore investment returns in Australian dollars, our base currency (when unhedged). Whether we look over the past year, or the past ten years, so-called US Exceptionalism has delivered market beating returns versus all other major global regions.

Earnings reality

One might logically infer that the superior returns from the US sharemarket should also be reflected in superior earnings growth for that region. This turns out to be correct versus most regions, although earnings growth in Japan has come close. Compared with Europe and especially Australia, ‘US Exceptionalism’ is far more evident.

In the charts below we plot cumulative earnings growth across the different regions, but we also break out the earnings of the S&P 500 Index with and without the ‘Magnificent-7’ technology companies (hence the ‘S&P 493 Index’). When these seven securities are excluded from the US index, growth has been on par with much maligned Europe!

In the chart below we've also added in the earnings growth of the Mag-7 securities. We need to use a different axis as the growth is off the scale!

Some observations:

• US earnings growth (S&P 500) was 7.3% p.a., similar to Japan, ahead of Europe (5.1%) and well above Australia (1.8%). But without the Mag-7, the “S&P 493” matched Europe.
• The Mag-7 delivered extraordinary growth — over 35% p.a. — with Nvidia alone compounding nearly 60% p.a. Due to their very large size, these seven companies dragged the returns for US markets up from 5.2% to 7.3% p.a.
• Australian earnings growth was just 1.8% p.a., dragged lower in recent years by fading iron ore profits. However, higher dividend yields have partly offset this from a total return perspective.
• These are local currency returns. When currency moves are included (strong USD, weak yen/euro) and valuation expansion, US dominance is even more pronounced. Strong earnings, strong dollar, high valuations — no wonder the US market has increasingly dominated the global cap-weighted indexes.

This earnings analysis raises the question: is the US market, in aggregate, genuinely exceptional?

The Mag-7 certainly are. But outside those names, earnings growth has been no better than Europe, and less than Japan. At least over the past decade, there is little evidence of “exceptionalism” across the broader American market.

The importance of income

Investors with a large exposure to Australian equities might be justifiably horrified that our own domestic market has delivered such measly earnings growth over the past decade, basically zero growth once inflation has taken its bite. Thankfully, earnings growth is only part of the story when it comes to investment performance.

Other sources of investment return include;

• Dividends received, including franking
• Earnings growth, which underpins dividend growth over time,
• Valuation expansion or contraction, which are mean reverting over time,
• Currency gains or losses, which also mean reverting

Despite meagre earnings growth, the Australian market’s fully franked dividends have added nearly 6% p.a. to returns, a consistent and powerful contribution.

While earnings growth and income are linked, the beauty of income is that it requires zero earnings growth to contribute to return. This characteristic adds an element of certainty to an investor’s return, plus has the potential to ‘smooth the ride’ as and when the economic cycle fluctuates.

Over the next decade, should returns from valuation and currency turn into headwinds[2], plus the ‘off the scale’ growth from the Mag-7 technology shares fade, then returns from income are likely to become an increasingly valuable source of return. 

‘US Exceptionalism’ has been a winning strategy for Australian investors simply by buying an unhedged index exposure… winning on earnings growth, winning on greater valuation expansion, and winning on a strengthening US dollar. Despite this, when we lift the hood on the composition of earnings we question the exceptionalism narrative as it applies to the broader American share market and believe the next ten years may look a lot different than the past.

With elevated Australian dividend yields offering consistency and stability, perhaps it is Australian exceptionalism,  from a fully-franked dividend yield, that investors should value most.

At Elston, we manage multi-asset portfolios designed to deliver consistent outcomes for investors by combining strategic asset allocation, active management, and a focus on income. Discover more about our approach here.