DUHP - DUHP: Excellent Quality Soft Growth Valuation Issues Under The Hood

2023-04-06 13:16:12 ET

Summary

• DUHP is an actively managed fund, with the cornerstone of its equity strategy being the profitability factor.
• DUHP has had a solid start to its trading history, with returns delivered since February 2022 demonstrating the robustness of its quality-centered strategy.
• DUHP falls into the category of those ETFs that have phenomenal profitability characteristics that come with issues on the valuation side, as well as lackluster growth.
• Despite its advantages, mostly because of the valuation issues uncovered, I would opt for a Hold rating at this time.

Dimensional US High Profitability ETF ( DUHP ) is an actively managed fund, with the cornerstone of its equity strategy being the profitability factor.

DUHP has had a solid start to its trading history, with returns delivered since February 2022 demonstrating the robustness of its quality-centered strategy. More specifically, during the March 2022 - March 2023 period that we will be discussing in greater depth below in the article, DUHP managed to eke out a small gain while its peers, the iShares MSCI USA Quality Factor ETF ( QUAL ) and Invesco S&P 500 Quality ETF ( SPHQ ), which pursue heavyweight top-quality names, were both down, and the iShares Core S&P 500 ETF ( IVV ) also performed rather poorly.

With that being said, instead of touting its advantages, for a more balanced overview, I would like to focus on the fund's downsides, namely related to its overreliance on mega caps and the supervening valuation issue.

How does DUHP define profitability?

According to the prospectus available on its website ,

The Portfolio is designed to purchase a broad and diverse group of readily marketable securities of large U.S. companies that the Advisor determines to have high profitability relative to other U.S. large cap companies at the time of purchase. An equity issuer is considered to have high profitability because it has high earnings or profits from operations in relation to its book value or assets.

I believe this is an interesting interpretation of the profitability factor, and numerous strong-quality stories should be present in DUHP's portfolio.

Addressing value and quality exposure

As of April 5, there were 178 stocks in the fund's portfolio, with the principal ten holdings - including the primary two Apple ( AAPL ) and Microsoft ( MSFT ) - accounting for ~31.1% of the net assets. The three key sectors in the mix are IT (25%), industrials (18%), and healthcare (13.9%). At this point, DUHP holds almost exclusively mega and large caps, with the weighted-average market cap standing at $361.6 billion, as per my calculations. The mid-cap echelon is represented, though obviously its impact on the total returns of this vehicle is microscopic as only 22 companies with market values less than $10 billion have qualified, with a weight of just a 1.8%.

From that data, we can already suggest that the fund should have a disproportionately small exposure to the value factor, as equities tend to become relatively more expensive as they climb to the upper echelon, and vice versa. Looking at its weighted-average earnings yield of ~5.6%, as per my calculations, an investor might assume this suggestion is a cursory one, considering the S&P 500 index is currently yielding only about 4.8% as per the data available on the SPDR Portfolio S&P 500 ETF ( SPLG ) website . However, this is just the very tip of the iceberg.

First, it seems that in the current iteration, the fund is almost completely ignoring the growth factor. More specifically, the WA forward earnings per share and revenue growth rates are fairly bleak, at ~8.2% and ~6.2%, respectively, as per my analysis. At the same time, the S&P 500's estimated 3-5-year EPS growth is about 12%. Moreover, comparing the forward EYs, DUHP appears to be overvalued, with a yield of ~4.6% vs. ~5.3% of the bellwether index. For the sake of clarity, the ETF's ~5.6% last-twelve-months EY is not impacted (too much) by loss-making companies that somehow qualified for inclusion in this profitability-focused fund, nine in total, with a weight of only around 1.3%. I will return to the discussion of quality characteristics shortly.

Next, what is also certainly worth mentioning is that almost 67% of DUHP's holdings have a D+ Seeking Alpha Quant Valuation grade and worse, with the above-mentioned AAPL and MSFT meaningfully contributing to this result. There are a few notable value stories under the hood, including International Business Machines ( IBM ) and QUALCOMM ( QCOM ), with stocks having at least a B- Valuation rating accounting for over 16% of the portfolio, but I consider this to be insufficient.

Exemplary q uality characteristics

DUHP is obviously capable of selecting top-quality companies, which is evident from over 99% of the holdings having a B- Quant Profitability grade and higher. Around 93.5% are A-rated (including A+ and A-). This is one of the highest results amongst the ETFs I cover.

Do DUHP holdings have a debt issue?

I perfectly understand why investors want to mitigate risks stemming from burdensome debt exposure at this juncture. With interest rates on the rise and the supervening capital shortage to continue for some time, with the consequences of tighter credit conditions yet to be seen in their entirety, it is wholly reasonable to maintain only modest exposure to companies much dependent on borrowed funds.

To check whether DUHP has a debt issue, we can use the Return on Equity/Return on Assets spread. An abnormally high ROE might point to the fact that most holdings have small book values as a consequence of too much debt on the balance sheet. However, DUHP's case is not a straightforward one. With a weighted-average ROE above 75%, a few of the fund's holdings should have a debt issue. However, a fairly healthy ROA of around 14% points to the contrary. Also, I decided to take a look at leverage (total debt/EBITDA), and it appeared that over 72% of companies in this portfolio have the ratio below 3x, a level I consider more than adequate.

So in sum, the ROE figure is inflated likely due to contributions from names like Seagate Technology ( STX ) and Mettler-Toledo International ( MTD ), which have ROE of over 2,207% and over 889% , respectively, and the share of debt-laden companies in the portfolio is moderate.

A few essential remarks for dividend investors

There is a myriad of examples when class-leading profitability is synonymous with strong dividend and/or dividend growth stories. For DUHP, there are a few nuances.

• First, as a solid share of the holdings are priced generously, its weighted-average dividend yield is expectedly bleak, only around 1.9%, as per my calculations, which is only ~21 bps higher than the yield of the S&P 500 index. This is most likely the primary consequence of the high-quality premium. Another reason might be a meaningful share of its holdings sticking to rather conservative dividend policies, retaining most cash generated.
• Second, 33 companies do not pay a dividend, at all (7.8% weight). This is another adverse factor influencing the DY.
• Nevertheless, DUHP has solid exposure to leading dividend growth names and dividend quality stories. More specifically, around 77.6% of the stocks in its basket have a Quant Dividend Safety grade of no less than B-, while close to 48% have a 3-year DPS CAGR of 10% and higher.

Still, principally owing to the low yield, I believe this ETF is a suboptimal choice for dividend-oriented investors.

Final thoughts

To sum up, profitability-focused strategies are personal favorites of mine, though there are nuances, and not every single quality and quality-ish fund is a Buy. Unfortunately, DUHP falls into the category of those ETFs that have phenomenal profitability characteristics that come with issues on the valuation side, as well as lackluster growth which amplifies the valuation issue.

However, it is not to be overlooked that even though its equity mix does not appeal to me, DUHP managed to deliver fairly decent results since its inception in February 2022, especially assuming that its first trading year was marred by the bearish forces dominating the market. Below is the table comparing DUHP's performance over the March 2022 - March 2023 period to IVV, QUAL, SPHQ, and JPMorgan U.S. Quality Factor ETF ( JQUA ); an important remark is that all the funds selected for comparison are managed passively.

Created by the author using data from Portfolio Visualizer

During that period, it outperformed almost all peers except for JQUA; another advantage is that the standard deviation was among the lowest.

Finally, it is also worth noting that DUHP has a fairly modest expense ratio of only 21 bps. Nevertheless, despite its advantages, mostly because of the valuation issues uncovered, I would opt for a Hold rating at this time.

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