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

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.

As one of the first dividend-themed ETFs, iShares Dow Jones Select Dividend Index quickly gained a wide following as assets surged to $12 billion. A large asset base can cause liquidity problems for a mid-cap portfolio, particularly an index fund that is a forced buyer of stocks in order to adhere to its index. The fund became so large that it held more than 5% of the outstanding shares of a number of stocks. Once a fund holds more than 5%, it must file a SEC Schedule 13D notifying the public. For example, iShares Dow Jones Select Dividend Index is the largest holder of tobacco firm Universal Corporation (UVV). Index funds usually do not want to be in a position where they are one of the largest shareholders of a firm since passive index funds typically have no stance on how that business should be run. Imagine what would happen if this stock cut its dividend and fell out of the index. IShares Dow Jones Select Dividend Index would have to liquidate 12% of Universal Corporation's shares in a day.

Another reason to prefer Vanguard Dividend Appreciation over iShares Dow Jones Select Dividend Index is fees. The latter charges 0.40% compared with just 0.13% for the Vanguard fund. Lower fees typically lead to better performance. Since October 2007, Vanguard Dividend Appreciation has returned 4.7% annualized compared with 2.8% for iShares Dow Jones Select Dividend Index.

Don't get deceived by the higher current yield at iShares Dow Jones Select Dividend Index. Instead, take a patient approach. In the current environment, with this fund trading at a premium to Vanguard Dividend Appreciation, we think caution is in order.

 

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