HDV - HDV: Tactically Attractive High-Dividend Play

2023-08-18 01:50:41 ET

Summary

• To be prepared for a deeper correction, investors should consider adding more healthy value allocations while certainly not ignoring the quality factor.
• HDV is a dividend-yield-focused vehicle, offering exposure to top-quality, mostly old-economy U.S. stocks.
• Its value/quality mix is supportive of a Buy rating.
• The risks include growth rotation resuming as well as oil markets’ negative reaction to softer economic data from China.

The market has become pronouncedly nervous recently, interpreting even relatively bullish economic data in an outright negative way. The mood has become even gloomier since the Fed July meeting minutes were published. As of writing this article, the S&P 500 had finished in the red for three days in a row. With the prospects of the tech/growth rally resuming becoming murkier, more downside should be anticipated for portfolios that I at times call value-agnostic. This implies that, to be prepared for a deeper correction, investors should consider adding more healthy value allocations while certainly not ignoring the quality factor.

A nice example to consider for value investors seeking safety is the iShares Core High Dividend ETF ( HDV ), which comes with an LTM dividend yield of 4.14% and an expense ratio of 8 bps, which is exceedingly competitive compared to vehicles targeting similar investment themes like the WisdomTree U.S. High Dividend Fund ETF ( DHS ).

HDV offers a nice representation of attractively priced U.S. names, with a sizeable S&P 500 dividend aristocrat exposure beneath the surface as well. 13 dividend aristocrat names are present, accounting for a massive 41.4% of the net assets, including such stalwarts as Exxon Mobil ( XOM ) and Johnson & Johnson ( JNJ ).

According to its website , HDV tracks the Morningstar Dividend Yield Focus Index, which, as described in the rulebook ,

... is designed to track U.S. stocks with attractive dividend yields and strong financial quality. Constituents are selected from the Morningstar US Market Index and weighted in proportion to the value of their dividend payments.

Importantly, REITs are not welcome. The rulebook states that to become a constituent, a company must have either a wide or narrow Morningstar Economic Moat Rating, while those with a Morningstar Uncertainty Rating of Very High or Extreme are shown the red light. Besides, its Distance to Default must be "in top half of region sector cohort." Key 75 names with the strongest indicated dividend yields join the index. Reconstitution and rebalancing follow a quarterly schedule.

As of August 16, HDV had a portfolio of 75 companies, principally from the healthcare, energy, and financial sectors.

Across the portfolio, weights are not as evenly distributed as investors who are more into better-balanced smart-beta mixes would prefer, with the cohort of the key ten accounting for almost 55% and the ten smallest having a microscopic 70 bps weight. However, this is more of an advantage as the top-heaviness grossly contributed to HDV's quality profile, with every single constituent from the 10 group having an A+ Quant Profitability rating, as the table below illustrates.

Created using data from Seeking Alpha and the fund

Overall, portfolio-wise, we see a wide array of preeminent quality stories, with holdings boasting a B- grade or better having close to 95% weight. Moreover, delving deeper into the portfolio, I found out that loss-making names are simply absent, while those with negative cash flows account for only 2.8%. ROE and ROA, my metrics of choice when it comes to financials-heavy ETFs, again illustrate how resilient the HDV portfolio is, standing at 29.7% and 8.6%, respectively.

As I said above, this ETF should appeal to value investors who are actively seeking safety amid weakness in the market. First, HDV's meaningful value factor exposure is manifested in its earnings yield of 7.3%, according to my calculations. This is a solid result for a portfolio with a weighted-average market cap of $190.2 billion and the quality characteristics discussed above. Also, it chimes well with a ~5% EPS Forward growth rate. Cash-based metrics perspective with certain financials removed is also supportive of a value thesis, as the cash flow yield (net CFFO/Enterprise Value) stands at 9%. Finally, 18.1% of the holdings have a Quant Valuation grade of B- or higher, which is an adequate result for a top-quality mega-cap mix.

HDV Tends To Perform Poorly When Growth Is In Vogue

The first risk to consider is that, being overweight in old-economy low-P/E sectors, HDV tends to underperform when growth style dominates the market. To corroborate, in 2020, amid the vigorous growth rotation, HDV declined by 6.47%; this year, amid the inflation narrative fading away, the fund rose by only 1.97% in the first 7 months, underperforming the iShares Core S&P 500 ETF ( IVV ) by 18.68%. That is to say, should the recent softness be shrugged off, with growth stocks becoming investor darlings again, there is a risk HDV will be unable to catch up with the rally.

The following table presents a comparison of the performance delivered by IVV, DHS, HDV, and the Vanguard High Dividend Yield Index Fund ETF Shares ( VYM ) over the April 2011 - July 2023 period.

Created using data from Portfolio Visualizer

Unfortunately, the annualized return is hardly spectacular. However, the key reason is that it was impacted by the lackluster performance of value stocks in the 2010s. But in the current environment, HDV's value tilt is more of a tactical advantage.

A Hidden China Risk To Consider

My dear readers have likely noticed that HDV has a meaningful allocation to energy stocks, about 25.2% as of August 16. Here, there is a hidden China risk with regards to the oil price dynamics. More specifically, China, a global economic powerhouse, is currently sending mixed economic signals that are weighing on the commodity markets and, most importantly, on the oil price. These concerns are also reverberating through the copper, zinc, and other metals markets, with the Invesco DB Base Metals Fund ETF ( DBB ) down by more than 3% in one month, but softness in metals is not that important for HDV, which has just a 1.5% allocation to the materials sector.

On the positive side, hopes for more support from the Chinese government have already buoyed traders' sentiment, so in the best-case scenario, exposure to petroleum will bolster HDV's performance, not detract from it.

Final Thoughts

As the markets continue to digest mixed macro signals, responding nervously to any piece of news suggesting tighter credit conditions for longer, I believe it is worth considering value-heavy allocations. A nice idea here is to mix value and dividend factors, and HDV looks like a solid vehicle offering exposure to both. Thanks to old-economy sectors like energy and financials, it has a strong earnings yield which comes with a healthy EPS forward growth rate. The index takes quality screening seriously, so small wonder most components are grossly profitable. Importantly, there is even a significant presence of dividend aristocrats in this portfolio, which should appeal to investors who prioritize DPS durability above all. Next, HDV also scores relatively well against dividend growth metrics.

Also, my computations based on the data from Seeking Alpha show the weighted-average 5-year dividend CAGR of HDV's current holdings at 9%; this is a remarkable result.

For further details see: