HDEF - FNDF: Steady Growth Prospects And Higher Dividend Possible

2023-10-10 15:22:39 ET

Summary

• The Schwab Fundamental International Large Company Index ETF has outperformed the S&P 500 over the past year, contrary to the long-term trend. It also has a price performance lead over peers.
• The fund's fortunes are dependent on the global economy, which is expected to stay steady in the next year and falling inflation can lead to higher margins as well.
• Its dividend yield, which lags peers so far can benefit from this. As such, as an investor in large companies, it also offers security at any time, irrespective of where the world is at.

Over the past decade, the Schwab Fundamental International Large Company Index ETF (FNDF) has provided underwhelming returns. Its price returns are at just 13.5%. While the performance improves when total returns are considered to be 46.9%, over the length of time in consideration, they still don't justify an investment in the fund. Especially not considering that the S&P 500 (SP500) has risen by 153% over this time.

However, over the past year, with over 26% total returns, the ETF looks more promising. This is especially true when considering that just the price returns have surpassed the S&P 500 over this time (see chart below). This then raises the question, can FNDF maintain its lead over the index in the foreseeable future?

Investing basis for the fund

The fund is based on the Russell RAFI™ Developed ex US Large Company Index, one of whose purposes is to support the creation of index tracking funds. The index's securities are selected and weighted on publicly available data on metrics like adjusted sales, retained operating cash flow and dividends, as well as buybacks.

As would be expected, changes in FNDF's net asset value closely correlate with the returns on the index (see table below), while the fund's market price fluctuates around the index. Neither the premium nor the discount is particularly significant for a length of time, though (see chart below).

Fund compares favourably

The fund also compares its performance with the MSCI EAFE Index , as the table above shows, having consistently outperformed by a small margin. Despite this, its price-to-earning ratio at 9.6x was lower than that of the MCI EAFE Index at 13.5x as of June 2023. There are differences between the index and the fund, though, that may well explain the performance gap.

The MSCI EAFE Index captures the performance of 795 mid-cap and large-cap companies across 21 developed countries outside of the US and Canada. FNDF has broader coverage with 923, only large companies, in its portfolio. It's also restricted to 10 developed countries and actually includes Canada, which has a non-trivial 6.6% share (see chart below).

Why the global economy is key

Significant as the domicile of the included securities appears, however, it's important to consider the fact that large companies, in general, tend to be globalised, and that's certainly true for FNDF's biggest holdings. This could also explain the difference in performance with the index. It also suggests that the fund holdings' outcomes are dependent on economies even outside the ex-US developed markets.

UK domiciled holdings

Consider its biggest holding, the UK-domiciled energy giant Shell (SHEL) as an example. Europe is indeed its largest market, but it has only a 35% share in total revenue in 2022. In fact, its APAC and Africa revenues come quite close, with a 33% share. The US alone accounts for another 23% of its revenues.

In fact, three of these top 10 holdings are domiciled in the UK, the maximum for any country (see table below). But the story is the same for the remaining two as well. Another big energy company, BP (BP), the fifth-biggest holding gets over 70% of its revenues from outside the UK and the banking and financial services provider HSBC (HSBC), its eighth-largest holding, is Asia focused.

Japan domiciled holdings

Similarly, Japan holds the biggest share among all holdings. But looking at the two stocks that feature in the top 10 - Toyota (TM) and Honda Motor (HMC) - reveals that they obtain 60% and 66% of their revenues from outside of Japan.

Prospects for the world economy

To this extent, the fortunes of the global economy need to be assessed, along with those of developed economies, to figure out what's next for FNDF. The good news is, that the world economy is expected to stay largely steady in 2024, with a 2.9% growth. Advanced economies are expected to show the same trend (see table below).

The Euro Area and Canada are even expected to see accelerated growth. While the US is seen slowing down from 2023, the fund has actually increased the economy's projected growth by 0.5 percentage points from its earlier projections.

But to my mind, the real positive is the continued expected slowing down in CPI inflation. In advanced Europe, inflation is expected at 3.6% in 2024 (2023 projections: 5.2%). Similarly, for economies like Japan, South Korea, the US, and Canada, inflation is expected to range between 2-3% in the next year, compared to a 3-4% range for 2023. This combined with sustained growth indicates that companies have an opportunity to continue expanding margins, particularly as PPI inflation remains muted .

Better dividends possible

This in turn can have a beneficial impact on FNDF's dividends. The fund has a trailing twelve-month [TTM] dividend yield of 3.2%, which is in any case higher than the median for all ETFs at 2.6%. The dividends are also largely safe, considering that it has paid them out consecutively for the past seven years.

While it does lag behind peers like Xtrackers MSCI EAFE High Dividend Yield Equity ETF (HDEF) and Invesco FTSE RAFI Developed Markets ex-U.S. ETF (PXF) in terms of yield, at 4.8% and 3.5% respectively, it does have better price returns over the past three years (see chart below).

What next?

Essentially, the comparison of peers indicates that over the medium term, the fund can outperform. Even on its own, though, FNDF doesn't look bad to me. Especially not at a time when the global economy is still not on a steady path. It's safer to invest in larger companies with global interests.

This is further reinforced by its steady dividend payouts, even if they are somewhat lower than peers' yields. I believe that these yields in fact can improve in 2024 if the global economy grows as projected, and doesn't throw up any nasty surprises. With CPI inflation expected to come off further, and subdued PPI trends, there's further potential for margin expansion going forward.

It's not likely to give exceptional returns over the medium term, going by the small share of even the biggest holdings in the fund, but it does offer a measure of predictability in both price and income returns at a relatively uncertain time. To answer the initial question, the fund may well maintain its lead over the S&P 500 at this time, but even if it doesn't, there are still good reasons to have it in the portfolio for the medium term. I'm going with a Buy on FNDF.

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