Few Can Match Vanguard Dividend Growth's Reliability

The following is our latest Fund Analyst Report for Vanguard Dividend Growth VDIGX

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Vanguard Dividend Growth's single share class earns a Morningstar Analyst Rating of Gold for reliability that few can match.

The fund stays true to its name, and it routinely shows in its concentrated portfolio. In December 2019, the 12.1% weighted-average dividend growth of the portfolio's 42 stocks over the prior fiscal year eclipsed the Nasdaq U.S. Dividend Achievers Select Index's 11.4% and was more than 12 times higher than the S&P 500.

Longtime manager Donald Kilbride believes dividend growth is the best sign of a company's ability to create lasting value and its willingness to share it. Deep fundamental research allows him to unearth opportunities that a simple screen wouldn't necessarily catch. In 2019's second half, for example, he looked past a then-recent lull in Deere's DE otherwise consistent record of growing its payout and built a 1.5-percentage-point stake in the agricultural equipment maker. He thinks Deere's efforts to increase recurring revenue through licensing precision software on its tractors should help fuel future dividend growth.

Whether the Deere position works out or not, Kilbride has distinguished himself as a skilled stock-picker. In the 107 rolling five-year periods since the Nasdaq benchmark's mid-2006 debut, the fund's returns through February 2020 beat that index in 102 of them while topping the large-blend Morningstar Category norm in 100.

The fund's consistent outperformance owes in large part to preserving wealth during drawdowns. It has lost less than its index as well as the S&P 500 in every market drop of 10% or more since Kilbride started on the strategy in early 2006. That includes February 2020's sudden plunge.

Since reopening to new investors in August 2019, the now $40 billion fund has taken in $3.7 billion of new money. Should inflows continue at that pace, Vanguard is likely to reclose the fund to new investors over the next year or two. Those on the outside looking in should consider this stellar option while they still can.

Process | High A disciplined, but not rigid, focus on dividend growth earns the fund a High Process rating. Manager Donald Kilbride looks for companies that have proved willing and able to increase their dividends over time but that are trading at reasonable prices. Ideally, he wants firms that can grow their dividends at the rate of inflation plus 3%. Often, he finds companies with five-year dividend-growth rates of at least 10%. The fund's holdings tend to be large blue-chip stocks that have big competitive advantages.

This is not a high-yield fund. Kilbride wants stocks that have the best prospects for steadily increasing their payouts rather than those that offer the highest current yield. Because he likes to buy when dividend-payers are out of favor, many of the fund's holdings may have respectable yields relative to the price at which they were bought, but the portfolio usually will not offer trailing 12-month or SEC yields as high as many other equity-income funds.

While Kilbride eliminates stocks that are likely to cut their dividends, he has on occasion added a stock after such a cut. He bought Pfizer PFE in 2009 after it chopped its dividend because he believed its merger with Wyeth would allow it to reignite dividend growth from a low base. He does, however, aim to keep portfolio turnover in check. The fund's 23% turnover in fiscal 2019 was well below most actively managed peers'.

Kilbride builds a compact portfolio of 40-50 stocks, dominated by big companies whose competitive advantages help them maintain and grow their dividends. At year-end 2019, the fund's $126 billion average market cap ranked in the large-blend category's top quintile, while its combined 93.2% stake in firms with a Morningstar Economic Moat Rating of wide or narrow was one of the category's highest.

The fund's sector weightings result from Kilbride's bottom-up focus on sustainable dividend growth. Thus, the fund holds few if any utilities as they tend not to have robust dividend growth. Within tech, he eschews capital-intensive businesses with short product life cycles and prefers instead mature service- and software-oriented firms such as top-10 holding Microsoft MSFT. Kilbride also likes companies poised to serve the needs of an aging population, which accounts for the fund's often hefty healthcare weighting versus the Nasdaq U.S. Dividend Achievers Select Index.

Kilbride is cautious about owning stocks in profit-challenged sectors, like energy. Since early 2016, he has had reduced expectations for oil and gas firms' long-term earnings because of the industry's geographical and geological challenges. After exiting the fund's position in Schlumberger SLB in early 2019, Exxon Mobil XOM, with its distinctive petrochemical business, is the portfolio's lone energy holding.

People | High The fund's manager is skilled, well-supported, and invests alongside shareholders. That merits a High People rating.

Wellington Management has run this fund in all its various guises, first as a utilities sector fund from its inception through late 2002, and since then as a dividend-focused fund. Donald Kilbride, the second person to apply the fund's dividend strategy, has been in charge since February 2006. He works closely with Peter Fisher, who lived in London from 2016 to 2019 to assess Europe's competitive dynamics. Since early 2017, Kilbride and Fisher have been a distinct two-person "dividend growth" team. While they’re likely to add an analyst over the next year or two, they suffer from no shortage or resources in the meantime. They remain in close contact with their former "quality value" teammates, including Edward Bousa and his mid-2020 successor Matthew Baker. They also make ample use of the firm's deep bench of global industry analysts, such as retail and restaurants specialist Evan Hornbuckle, who influenced the fund's Nike NKE and TJX Companies TJX positions.

Kilbride has decades of experience. Before joining Wellington in 2002, he worked for six years as the director of research at The Boston Company and prior to that at Greenberg-Summit Partners, where he covered energy and materials, among other sectors. Kilbride invests more than $1 million in the fund.

Parent | High The Vanguard Group entered a new era in early 2019 with the passing of its founder and conscience, John C. Bogle. Unlike its mid-1970s origins, when outflows were the norm and its survival was in question, Vanguard now wears the crown as the world's biggest retail asset manager. More than 90% of its $5.6 trillion in global assets under management, as of June 2019, are in the United States; but the firm has designs to grow its non-U.S. business, especially in the United Kingdom, Australia, Canada, Japan, China, and Mexico.

Vanguard gained its stature by following Bogle's playbook: pairing relatively predictable strategies, both passive and active, with minimal costs. That's enriched Vanguard's investors, and those outside its flock who have benefited from industrywide fee compression. While Vanguard's passive business now faces stiff price competition from its biggest rivals, inflows into its U.S. strategies still dominate.

Not content, Vanguard aims to transform investment advice, too. In May 2015, it launched Personal Advisor Services, a burgeoning discretionary asset-management business that pairs automation and human advice; and in September 2019 it disclosed plans to launch a digital-only counterpart. Vanguard's industry leadership readily merits a High Parent rating, but the firm must stay on its guard to prioritize investor interests over merely expanding its kingdom.

Performance The fund's performance has been stellar through a full market cycle. Its value-tilted focus on dividend growth tends to thrive when markets tremble. The fund's 42% cumulative loss from peak to trough in the 2007-09 credit crisis, while dreadful, beat the Nasdaq U.S. Dividend Achievers Select Index by 4.3 percentage points and landed in the large-blend category's top decile. The fund also preserved capital better than its benchmark and most peers in 2011's turbulence, the 2015-16 correction, and late 2018's near bear market.

The corollary of superior downside protection is that the fund's well-capitalized dividend-payers often lag when more-speculative fare surges. That was a factor in the fund's bottom-quintile showings in 2012 and 2016. Poor stock picks played a role, too. In 2012, a position in Western Union WU hurt the fund, and Donald Kilbride sold the stock in early 2013 when he became concerned about its dividend. In 2016, he bought McKesson MCK right before fears about price competition punished its shares.

While he is not immune to errant stock picks, Kilbride has consistently added value during his tenure. The fund's 9.3% annualized gain through February 2020 beat the Nasdaq index by an annualized 78 basis points since that bogy's late April 2006 inception. The fund also then surpassed the broader Russell 1000 Index by 93 basis points and ranked in the category's top decile.

Price It's critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its Morningstar Category's cheapest quintile. Based on our assessment of the fund's People, Process and Parent Pillars in the context of these fees, we think this share class will be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Analyst Rating of Gold.