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Home>Research & Insights>Investment Insights>High-Quality International Stocks for a Slim Fee

High-Quality International Stocks for a Slim Fee

Vanguard International Dividend Appreciation focuses on profitable firms that have consistently increased their dividend payments.

Daniel Sotiroff, 08/09/2017

Vanguard International Dividend Appreciation VIGI uses a strict but sensible strategy to invest in profitable firms from developed and emerging markets. The strategy screens for stocks with consistent long-term dividend growth and caps individual weights to reduce its exposure stock-specific risks. This is a solid and attractively priced strategy, but the fund’s short track record limits it to a Morningstar Analyst Rating of Bronze.

The fund invests in large- and mid-cap stocks from developed and emerging markets, and screens for those that have increased their dividend payments for seven consecutive years. The strategy applies additional filters that eliminate stocks which may not be able to sustain their dividend growth.

Holdings are weighted by market capitalization, which helps mitigate turnover and transaction costs. Individual stocks are limited to 4% of the portfolio at the annual rebalance, which improves diversification. The top 10 holdings currently account for about one third of the portfolio.

Many foreign stocks tie their dividend payments to earnings. Therefore, companies that have a history of increasing their dividend payments are also likely to be those that have been consistently growing profitably. This fund’s return on invested capital comes in at 17.3%, compared with 12.5% for the MSCI ACWI ex-USA Growth Index. It also lands in the top quintile of the foreign large-growth Morningstar Category.

Tying dividend payments to earnings also introduces certain risks. This policy can cause dividend payments to be more volatile than simply paying a consistent dividend. Additionally, a narrow focus on firms that consistently increase their dividend payments can emphasize those that are paying out a large portion of their earnings, which leaves a smaller fraction available for management to reinvest in their business. However, that tends to be a bigger risk with funds that focus on dividend yield.

This fund was launched in February 2016 and has not had sufficient time to build a meaningful record. Its absolute and risk-adjusted returns from March 2016 through May 2017 have landed in the middle of the category.

Fundamental View
Many of the fund’s dividend-oriented peers emphasize dividend yield rather than growth, but a narrow focus on yield brings about certain risks. High yields can be an indicator of firms that may be in financial distress, or have poor forward-looking prospects. These stocks trade at lower prices relative to dividends paid, and can be risky. Other high-yielding stocks may be paying out a large fraction of their earnings. These companies may be at risk of cutting their dividends because increasing payments in the future is unsustainable. Funds that hold these stocks tend to be more value-oriented, and more volatile than a broad market-cap-weighted index.

In contrast, this strategy focuses on dividend growth, which emphasizes companies that are more profitable and less likely to be in financial distress than their high-yielding counterparts. Consequently, this fund’s yield is lower than these yield-centric funds. Instead, the stocks in this portfolio typically represent highly profitable companies with strong underlying businesses. Strategies that invest in highly profitable companies have sound investment merit. In his 2012 paper, “The Other Side of Value,” Robert Novy-Marx demonstrated that profitable firms have historically outperformed unprofitable firms, and are less prone to distress.

The fund requires constituents have at least seven consecutive years of increased regular dividend payments. This is somewhat relaxed from the U.S. version of this strategy, Vanguard Dividend Appreciation ETF VIG, which requires 10 years of increased payments. The reduced hurdle was necessary because foreign companies typically tie their dividend payments to earnings, making payments more volatile than those from U.S. companies. As a result, fewer companies would be able to pass a 10-year growth screen. While the fund’s seven-year requirement is slightly less demanding, it improves diversification.

Firms that make the cut are typically more profitable, and generate more consistent earnings growth than average. As a result, this fund is skewed toward those from stable sectors such as consumer staples and healthcare. Top holdings include major multinational firms including Nestle NSRGYRoche RHHBY, and Novartis NVS. Companies such as these tend to be less volatile than the broader market, and should hold up better during market downturns. The holdings in this fund are also weighted by market capitalization, which emphasizes the largest companies that have consistently raised dividends, many of which have globally diversified revenue streams. The average market cap of this fund is one of the largest in the foreign large-growth category.

Broadly diversified international funds such as this one can hold stocks from emerging markets. Stocks listed in emerging market countries can be subject to various risks that threaten business growth and stability—among them, poorly maintained infrastructure and undeveloped regulatory systems. But 79% of the stocks in this portfolio are domiciled in mature developed-markets countries.

Portfolio Construction
This fund tracks the Nasdaq International Dividend Achievers Select Index, which targets companies that have a strong history of raising their dividend payments. Its market-cap-weighted approach further emphasizes large stable firms while mitigating turnover and transaction costs, and supports a Positive Process Pillar rating.

The selection universe for this index starts with stocks listed in the Nasdaq Global Ex-U.S. Index, and includes those listed in both developed and emerging markets. REITs and companies that are currently working through bankruptcy proceedings are excluded from the selection universe. Additional liquidity screens are applied as well. Selections are narrowed down to companies that have a seven-year history of increasing regular dividend payments. Nasdaq applies some additional secret screens intended to improve the chances of selecting companies that will continue to grow their dividends. Stocks that meet these criteria are weighted by market capitalization, subject to a 4% maximum weighting at the time of the rebalance. The index is reconstituted annually in March, and the managers use full replication to fulfill their index-tracking objective.

Fees
This fund’s 0.25% expense ratio is significantly lower than the 1.15% average in the foreign large-growth category. This should provide the fund with a durable advantage and supports a Positive Price Pillar rating. Additionally, the market-cap-weighted approach helps promote low turnover, which further reduces transaction costs and improves the cost of ownership. This fund’s last reported turnover ratio was one of the lowest in its category.

Alternatives
WisdomTree International Hedged Quality Dividend Growth IHDG targets 300 developed-markets stocks that score high on a combination of expected earnings growth and profitability. This approach directly screens for stocks that are likely to maintain or grow their dividends in the future, and gives the fund a growth orientation. Holdings are weighted by dividends paid, which can increase turnover and transaction costs. This fund also hedges its currency exposure, which can trigger capital gain distributions. It charges an expense ratio of 0.58%, and has a Bronze rating.

Vanguard International High Dividend Yield VYMI (0.32% expense ratio) sorts foreign dividend-paying stocks by forecast yield, holds those representing the higher-yielding half, and weights them by float-adjusted market capitalization. This fund does not perform any additional screening for quality or profitability, and may hold stocks with deteriorating fundamentals. The emphasis on stocks with high dividend yields introduces a value tilt to this portfolio, placing VYMI in the foreign large-value category.

A simple, low-cost, broadly diversified international fund, such as Vanguard Total International Stock ETF VXUS (0.11% expense ratio), might also be worth considering. This fund invests in both developed and emerging market stocks across the entire market-cap spectrum. It weights its holdings by market capitalization and carries a Silver rating.

 

Daniel Sotiroff is an analyst, passive strategies research, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.

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