FDL - FDL: The Dividend Leaders In The ETF Might Not Meet Expectations

2023-04-28 08:43:35 ET

Summary

• FDL aims to provide exposure to the 100 high-yielding dividend stocks that can consistently pay dividends.
• The ETF includes some Dividend Aristocrats, such as Exxon Mobil, but also holds companies with shorter histories of dividend growth.
• Investors should consider looking at other ETFs that only hold high-quality dividend stocks.

Introduction

Appearances can be deceiving, and this principle applies not only to life but also to investments. On the surface, an investment may seem promising, but upon closer inspection, it may not be as alluring. The First Trust Morningstar Dividend Leaders Index Fund ( FDL ) is a prime example of such an investment. Its name implies a focus on dividend leaders, and a glance at its top-10 holdings might reveal some exceptional dividend stocks, including Dividend Aristocrats. However, I believe that after one starts to examine the Dividend Leaders the ETF holds, FDL's appeal begins to fade. While the First Trust Morningstar Dividend Leaders Index Fund has some positive attributes, it's not all smooth sailing, and investors should consider taking a closer look before adding this ETF to their portfolios.

FDL's Investment Strategy and Composition

The First Trust Morningstar Dividend Leaders Index Fund, or FDL, aims to provide investors exposure to 100 of the highest-yielding dividend stocks that have maintained “consistent and sustainable dividend policies”. The ETF selects its holdings from the Morningstar US Market Index, a broad market index that represents approximately 97% of the US stock market's capitalization. Companies that fail to meet specific criteria, such as those with a low liquidity score, those not expected to grow dividends within five years, or those whose forecasted earnings per share for the upcoming year are not greater than their dividend payments, are excluded. FDL then ranks the remaining stocks based on dividend yields and invests in the top 100.

The ETF employs an "indicated dividend dollar-weighted methodology" to rank stocks in its portfolio while ensuring that no single holding accounts for more than 10% of the ETF, and the total weight of all holdings that individually exceed 5% stays below 50%. Although this approach results in a top-heavy fund, with its largest holdings constituting more than half of the fund's assets, it does not overly favour a single stock. With its top holding accounting for around 10% of the ETF, any significant negative impact on the fund's performance due to that particular stock's decline is unlikely.

FDL holds $5.13 billion in net assets and offers a dividend yield of 3.75% (30-day SEC yield of 4.79%), which is higher than the S&P 500's average of 1.66%. The ETF's top three holdings are Exxon Mobil ( XOM ), AbbVie Inc. ( ABBV ), and Verizon Communications ( VZ ), representing 10.7%, 8.27%, and 7.8% of the ETF's assets, respectively. The top 10 holdings account for over half of the ETF's assets, indicating that while no single stock's performance can greatly affect FDL, the collective performance of the top 10 can impact the ETF's overall performance.

Image: Author. Data: Seeking Alpha

Top 10 Holdings and Dividend Leaders

Some market commentators have highlighted FDL as an ETF that applies the Dividend Aristocrats concept to construct its portfolio, and a quick glance at the fund's top 10 holdings reveals that it indeed holds some high-quality dividend-paying companies. Its top 10 holdings consist of well-established names, with nearly all of them demonstrating a strong history of consistently increasing dividends for eight years or more.

Image: Author. Data: FDL, Dividend.com

In fact, Pioneer Natural Resources ( PXD ) is the only company among FDL's top 10 holdings that hasn't been growing dividends for years. However, I believe this third-largest Permian Basin oil producer is well-positioned to increase dividends in the future. The company has experienced a significant boost in earnings and cash flows over the past couple of years due to rising oil prices, generates ample free cash flows (FCF yield of 13%), and maintains a robust balance sheet with a debt-to-equity ratio of just 23%. Although the company lacks a lengthy history of regular cash dividend payments, it is establishing a reputation for returning substantial cash to shareholders through variable dividends.

As shown in the table above, FDL has three Dividend Aristocrats – stocks that have consistently grown dividends for at least 25 years – among its top 10 holdings. This includes its largest holding, Exxon Mobil, which has been increasing dividends for four decades and shows no signs of stopping anytime soon. The company’s profits and cash flows have soared in recent years, thanks in large part to the increase in oil prices. Exxon Mobil reported a record-setting net profit of $56 billion last year and returned $30 billion in cash to shareholders. Factors such as production growth, cost savings, improved product mix, and consistently high oil prices will likely boost its earnings in the coming years. This solid financial performance will lay the foundation for increased shareholder payouts in the form of higher dividends in the future.

Caveats and Concerns with FDL

At first glance, FDL seems to be an attractive investment opportunity. However, as with many things in life, what looks good on paper may not hold up under closer examination. While there are undoubtedly positive aspects of this fund, I think this ETF is not as good as it seems on paper.

That's because firstly, FDL calls itself as a fund that holds Dividend Leaders with "historically consistent and sustainable dividend policies." These terms might lead some to assume that FDL holds companies (like Dividend Aristocrats, Kings, or Champions) that have an established track record of consistently growing dividends for years. However, FDL has not said that it screens stocks based on an extensive history of dividend growth. Consequently, the ETF includes several companies, even one in its top-10 holdings, which lack a substantial history of consistently increasing regular cash dividends.

In fact, out of the 100 stocks held by FDL, 41 have grown dividends for just five years or less, with the majority (27 securities) showing no years of dividend growth in their history. Not all of these companies are in strong financial positions like Pioneer Natural Resources. For instance, FDL holds Newell Brands ( NWL ), a company with no history of growing dividends and a dividend safety score of 'F' on Seeking Alpha. While most of these stocks with a dividend growth history of five years or less carry a portfolio weight of less than 1% each, together, they represent a little over 18% of FDL's assets. Individually, they might not seem significant, but collectively, they form a notable portion of the ETF and could negatively impact its performance.

Image: Author. Data: FDL Holdings , Dividend.com

Secondly, it seems that dividend yield plays a significant role in FDL's stock selection process, which could explain the inclusion of companies like Newell Brands in its portfolio. On its website , the ETF states that after filtering stocks from the Morningstar US Market Index based on earnings estimates and dividend projections, the fund ranks stocks by "indicated dividend yield," and the "top 100 are then selected for inclusion in the index". The stocks are then weighted on the basis of the dollar value of their dividend payments. However, this reliance on dividend yield can occasionally be problematic, as a higher yield can also signal an impending dividend cut.

Take Newell, for instance, which can face weak demand due to the tough economic environment. Additionally, this consumer discretionary company carries a massive debt load, as evident from its debt-to-equity ratio of over 170%. In fact, S&P Global recently downgraded Newell's credit ratings to junk status. With pressure on sales and a large pile of debt, it remains questionable whether the company can continue paying dividends at the current rate. That's weighed heavily on the stock which has fallen by more than 20% in the last three months. It now offers a dividend yield of 7.8%, with the high yield likely indicating that the market is pricing in a dividend cut.

I believe that if you’d like to invest in Dividend Leaders or great dividend stocks or those with a long history of consistently growing dividends, then FDL may not be the right choice for you. Instead, I recommend exploring other options such as ProShares S&P 500 Dividend Aristocrats ETF ( NOBL ), which invests in companies that have been growing dividends for the last 25 years or more. NOBL exclusively holds companies that have been consistently rewarding shareholders for decades, including many like Exxon Mobil, which have been increasing dividends for over three decades (such as PepsiCo ( PEP ), Chevron ( CVX ), and Johnson & Johnson ( JNJ ))

In my opinion, if the economic environment worsens, investors may shift away from relatively riskier companies or those without a history of dividend growth, such as Newell Brands held by FDL. They might opt for well-established dividend payers found in NOBL and other similar ETFs. In this context, FDL may underperform, especially when compared to ETFs like NOBL. In fact, over the past six months, NOBL has risen by 6.5%, while FDL has fallen by 0.7% during the same period. I believe this trend could continue in the future. For a slowing economy, I think investors should consider buying ETFs that hold high-quality dividend stocks and avoid FDL.

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