VTI - DVY: Not Perfect But Not A Bad Bet At This Juncture Either

2023-08-11 13:46:51 ET

Summary

• iShares Select Dividend ETF is a stable ETF that provides access to high-dividend-paying US stocks across various market caps.
• DVY uses a nuanced and layered screening strategy to select high-quality stocks based on dividend criteria.
• There doesn't appear to be any significant edge in owning high-yielders either from a return perspective or risk angle.
• DVY's high exposure to mid-caps and utilities could prove to be fruitful in the medium term.

Useful Screeners

The iShares Select Dividend ETF ( DVY ) is a 20-year-old stable (annual portfolio turnover ratio of only 15%) ETF, that seeks to provide access to around 100 high-dividend paying US stocks across different market-caps (do note that REITs are excluded from the list).

Rather than using a perfunctory screening strategy of randomly picking the top 100 US yielders based solely on the historical yield, DVY resorts to a more nuanced and layered approach, which we think helps bring through better quality stocks.

For further clarity, note that prospective stocks from the Dow Jones U.S. Index are required to pass four key dividend-based criteria :

The regular payment of dividends for five consecutive years; an absolute dividend per share ((DPS)) figure that is equal to or larger than its 5-year average DPS; non-negative 12-month trailing earnings; and a 5-year average dividend coverage ratio of at least 167%.

Once all these criteria are met (in addition to a market cap and volume screener), the top highest-yielding stocks by indicated yield (special dividends are excluded) are chosen with larger weights assigned to the highest yielders (individual weights are capped at 10%).

How Has DVY Performed?

All these years, has there been sufficient merit in pursuing a portfolio of the highest-yielding US stocks? Or, would one just be fine by purchasing the entire market, as represented by the Vanguard Total Stock Market ETF ( VTI )?

Well, if you only want to look at price appreciation, it's worth noting that VTI's return profile comfortably trounces DVY by 2.6x.

But perhaps looking at price returns alone wouldn't be fair to DVY as there's a long-standing dividend distribution sub-plot to inculcate. For context, also note that DVY's yield has consistently been over 2.17x greater than VTI's corresponding yield average.

Well, if we account for distributions and look at total returns, the variance between the two certainly narrows, but yet still, VTI still outperforms DVY by close to 1.5x

Beyond returns, it also may be worth looking at these ETFs' respective risk profiles, and how they've managed to generate returns given the degree of risk they take.

So, what we can see is that when DVY first started trading and for close to 5-6 years, it was chasing high-yielders with an inherently low-risk profile. For its low volatility profile, the quality of excess returns it was delivering (over the risk-free rate) was also at a remarkably high threshold with the Sharpe ratio hovering over 1x, and even hitting levels of 2x.

However, over time, all that has changed as DVY's volatility profile has moved in line with the total stock market, and even its Sharpe ratio has dropped well below 1x and is currently even lagging VTI's corresponding figure. This implies that the high yielders may satisfy you from an income angle, but as far as share price appreciation and risk management is concerned, there's no great edge in owning them,

Closing Thoughts - Is DVY A Good Buy Now?

As noted earlier, DVY offers a compelling enough yield, which is currently roughly 40bps more than what you normally get. From a valuation perspective as well, things look relatively attractive with this portfolio only trading at a weighted average P/E of less than 12x , a 39% discount to the total stock market.

However, do also consider that DVY is not overly exposed to the high growth side of the market. In fact, a steady or low-growth industry such as utilities accounts for the largest share of this portfolio. Unsurprisingly, you're unlikely to get the benefit of superior earnings growth potential (and the associated valuation expansion) if you attach yourself to DVY. According to Morningstar, DVY's holdings will likely only offer long-term earnings growth of 8% (for context, VTI's holdings offer 11% earnings growth).

However, if one looks at the relative strength positioning of utilities, it's fair to say that things look rather oversold and there could be some potential mean-reversion activity. Currently, the utilities to broad market ratio is trading around 28% off the mid-point of its long-term range.

Yesterday's CPI report may likely also boost the enthusiasm of utility bulls. On an annual basis, core inflation grew at a slower rate than in June, and it was also the lowest reading since October 2021. This could likely embolden the Fed to pause its rate-hiking ambitions in September. Going forward the CPI could meaningfully drop as it's currently largely being driven by shelter costs which typically lag market rents, the impact of which has already been felt. Given how much debt these utilities carry in their capital structure (their debt appetite is only overshadowed by the banking sector), a pause in rates should be seen as positive for this sector. We also may be inching closer to a cut in rates, which could boost utility's positioning as an attractive defensive asset class relative to bonds.

The other major standout theme of DVY is that it's dominated by mid-cap stocks, which account for 57% of the total portfolio. This is another part of the broad market which could potentially benefit from some mean-reversion momentum. The image below juxtaposes US mid-cap stocks against the total stock market, and we can see that the ratio has now dropped to levels last seen during the GFC, after which there was a quick rebound.

Finally, if we look at DVY's weekly price imprints over the last 12-18 months, we can see some range compression with two black converging boundaries over time. If one were to contemplate a long position at this juncture using the two boundaries as prospective pivot points, the risk-reward looks about fair.

To conclude, whilst we acknowledge that there does not appear to have been any significant edge in holding high-yielding US stocks for long periods, at current levels, we think a long position in DVY wouldn't be the worst idea around.

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