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Defensive Sectors, the Playground of Dividend-Themed Funds, Look Overvalued

Demanding a quick return and shorter payback, investors bid up higher-yielding but potentially slower-growing stocks.

Michael Rawson, CFA, 05/03/2013

These days, equity investors seem to be following the playbook of "Jerry Maguire": Show me the money! The higher the yield, the better. No one has the patience or risk tolerance to wait around for the return on long-term or capital-intensive projects. Apple AAPL just issued $17 billion in debt so it could hand over the money to shareholders.

The preference for current income is reflected in the fact that companies from defensive sectors are currently trading at a premium valuation. Defensive stocks typically have higher dividend payouts because they are in mature industries, have few opportunities for organic growth, and have less of a need to reinvest cash internally. Because of their slower growth, we would expect them to trade at a discounted valuation. But that is not what we see in the current environment. The table below shows the 10 Global Industry Classification Standard sectors applied to the stocks in the S&P 500 Index. Consumer staples stocks currently trade at the highest price/earnings valuation despite the fact that their earnings are expected to grow more slowly than in other sectors. Even utilities are trading at a high price/earnings valuation despite only a 5% earnings growth forecast.

iShares Dow Jones Select Dividend Index DVY and Vanguard Dividend Appreciation VIG are the two largest dividend-themed exchange-traded funds. These ETFs follow different approaches that result in dramatically different portfolios. Dividend-themed funds typically load up on stocks from defensive sectors. DVY has a massive 32% weight in utilities, compared with just 2% in VIG. At the same time, DVY is underweight traditionally faster-growing but lower-payout categories such as information technology and health care.

The result is iShares Dow Jones Select Dividend Index has a higher yield of 3.3%, but the companies in its portfolio have only grown earnings by 5.9% during the past five years. Meanwhile, companies in Vanguard Dividend Appreciation have grown earnings at a much faster 10.4%, but the fund has a dividend yield of only 2.1%. This much lower yield results from the fact that firms in Vanguard Dividend Appreciation only pay out about 35% of earnings a year, while firms in iShares Dow Jones Select Dividend Index pay out 69%. In part because of the larger payouts, investors have rewarded stocks in iShares Dow Jones Select Dividend Index with a premium valuation. It trades at a price/fair value of 1.07, while Vanguard Dividend Appreciation trades at only 1.02.

The lower payout ratio at Vanguard Dividend Appreciation means that those companies have more money left over to support their brands, launch new products, or invest in new businesses. This should result in faster earnings growth in the future. It seems that investors couldn't care less.

While both iShares Dow Jones Select Dividend Index and Vanguard Dividend Appreciation cater to dividend-paying stocks, differences in construction result in portfolios that perform differently. Vanguard Dividend Appreciation looks for companies that have increased dividends for at least 10 consecutive years, which is a period long enough to include multiple business cycles. In order to increase dividends consistently, these companies need to have either strong brands or a monopolylike competitive position--in other words, wide economic moats. Vanguard Dividend Appreciation has 59% of its assets in wide-moat companies, compared with less than 18% for iShares Dow Jones Select Dividend Index. Defending a moat requires continued investment. While it might be possible to pay out a large dividend for a few years, ensuring that the dividend can grow over 10 years requires long-term investment. Finally, Vanguard Dividend Appreciation weights firms roughly by their market cap. This results in a large-cap portfolio that does not give undue weighting to a handful of higher-yielding but riskier stocks.

On the other hand, iShares Dow Jones Select Dividend Index selects high-yielding companies that meet various financial health screens. Oddly, it then weights them by the dollar amount of dividend per share, resulting in more of a mid-cap portfolio. The index has no sector-limit constraints, so large sector overweighting can develop in the portfolio. For example, at the end of 2007, nearly half of the portfolio was invested in financial services stocks. During the financial crisis, weaknesses in iShares Dow Jones Select Dividend Index's methodology were exposed, and the fund had a max drawdown during that period of 57%, compared with a 41% fall for Vanguard Dividend Appreciation.

Michael Rawson, CFA is an ETF Analyst with Morningstar.
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