HDV - HDV: Opportunity Cost

2024-01-03 03:10:57 ET

Summary

• HDV ETF has not beaten the market or peers.
• The portfolio of HDV consists of mature businesses with low revenue and EPS growth.
• The ETF is expensive relative to its EPS growth with a 2.7x PEG.
• There are much better options for investors seeking dividends, growth, and lower volatility.

Summary

I would venture to say that most investors who seek high dividend-paying stocks are also looking for growth, fundamentally resilient businesses with low overall volatility (Beta) than the broader market as measured by the S&P 500 ( SPX ). The yield may not be the primary decision metric but one that leads to those low-volatility blue chip stocks. Pure yield or income seekers can find a plethora of far higher rate options in bonds, BDCs (Business development companies), preferred shares, option call written premiums, and REITS that are wrapped in closed-end funds with or without leverage.

Investors searching for fundamentally solid companies with high dividend yields may have come across the iShares Core High Dividend ETF ( HDV ) that has US$10bn in AUM and competes with Vanguard High Dividend Yield Index Fund ETF Shares ( VYM ) and many other dividend-seeking ETFs and Funds. I did not find HDV compelling on almost any measure, a forward 2024 yield of 3.4%, an estimated upside of 9% nor its relative valuation at 2.7x PEG (PE to EPS Growth).

Performance

I compared HDV performance, adjusted for dividends, to the SP500 and a few other ETFs with a quality and/or moat strategy. The results are mediocre vs all but investment-grade bond funds.

Index Construction

At the core of HDV strategy is full replication of the Morningstar® Dividend Yield Focus Index , which selects the top 75 stocks based on quality standards as well as the highest dividend yield. Selected companies must have a high credit quality and a measurable Moat based on Morningstar criteria. This Moat screen led me to make a connection with another fund I have covered that uses the Morningstar selection process the MOAT: A Strategy That Generates Alpha [MOAT]. However, as the following fundamental analysis of the ETFs holding bares out, the lack of earnings growth makes this an expensive portfolio.

Portfolio Return Perspective

I calculated a 9.2% upside to year-end 2024 using consensus price targets for 80% of the AUM or 24 stocks in the portfolio. The total return estimate of 12.6% seems reasonable and in line with the SPX. There is a high concentration of oil stocks (22%) that I would classify as far more volatile than much of the SPX given their dependence on oil prices.

Revenue Growth and Margins

To gauge the quality of the ETF holdings I calculated revenue growth and EBITDA margins using consensus estimates. The portfolio has weak revenue growth of just 2% but very solid and increasing margins that help drive EPS. This is a portfolio of mature businesses with reasonable moats.

EPS and Dividend Growth

As can be already concluded, the ETF´s portfolio of low-revenue stocks leads to consensus EPS growth of 2% in 2024 and 4% in 2025 (adjusting for Merck’s ( MRK ) recuperation year). DPS is estimated to grow faster at 4% in 2024 and in line with 2025 EPS growth. The payout ratio (percentage of EPS that is distributed as dividends) is a healthy 43% which may be viewed as a positive metric and that could support higher DPS even in a declining earnings environment.

Valuation is a Problem

The HDV hits a sore point when it comes to valuation. Despite a seemingly cheap PE of 10.9x for YE24 (based on consensus EPS) the relative growth metric or PEG is 2.7x vs the SPX of around 1.8x, this means that the portfolio could be a value trap. The holdings are all fundamentally sound companies with high dividends that are expensive vs their EPS growth outlook.

Conclusion

I rate HDV a sell. I see two risks to owning this ETF, one is that it is expensive relative to EPS growth and could underperform the market, especially in a rate-cut environment. This leads to the second risk and that is opportunity cost, most investors have limited capital and should look for the best risk-reward equation within their parameters and this ETF seems to not have the ability to beat the market nor to generate high yields.

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