SDIV - SDIV: Chronic Underperformance To Worsen As Global Economic Stagnation Spreads

Summary

• As the global economy falls into chronic stagnation, companies with poor balance sheets or competitive risks will likely experience significant declines.
• The ultra-high yield ETF SDIV is popular due to its double-digit yield despite chronic underperformance.
• In my view, SDIV usually underperforms because it selects battered-down companies that continue to pay dividends at the expense of their financial stability.
• With the PMI and yield curve signaling economic contraction, investors may be wise to avoid SDIV's "deep value" companies since a recovery appears unlikely to occur soon.
• With interest rates as high as they are, income-oriented investors may find much better risk-reward opportunities among short-term bonds.

Over the past year, stocks and ETFs that took significant hits during 2020 have fallen even lower. While the global economy is not necessarily in a "recession," it has fallen into a chronically stagnant growth state. Most developed countries' real GDP has not risen since 2019, with some expecting declines this year. This dynamic is atypical in that the global economy is not experiencing a rapid but short-lived contraction but a long, drawn-out period of consolidation. The pattern is similar to the 1970s to early 1980s, where rapidly rising prices and low production growth led to prolonged economic stagnation .

I believe investors should take note of this trend as it drastically changes the risk and reward environment facing most companies. In general, I suspect interest rates will remain elevated in the US for a prolonged period and continue to rise in most other "developed" economies. This is a challenging environment for businesses, but with the odds of a very sharp economic contraction low (compared to a likelier prolonged stagnation), only the worst-performing companies are likely at risk of bankruptcy. Instead, moderate inflation and interest rates should compress profit margins and limit sales growth - trends that jeopardize companies struggling with high leverage or competitive pressure. In the market, this trend will likely mean the worst-performing stocks will continue to slide since there is no cyclical economic recovery (or supportive monetary shift) to boost them.

This theme is discussed in many of my recent single-stock articles but is also relevant to a few ETFs. Specifically, those ETFs that predominately own battered-down companies. Even stocks with low "P/E" ratios may fall lower as their earnings prospects face challenges. One notable example is likely the ultra-high dividend ETF SuperDividend ( SDIV ). SDIV is very popular among income investors due to its 14% trailing yield and global exposure. While there is a lot to like about SDIV, I believe the fund will likely continue to burn more value than it generates until the global economic environment changes.

The Core Issue in SDIV's Strategy

I covered SDIV last around the end of 2020 as the ETF was recovering from its massive COVID crash. At the time, I warned investors that its trailing yield was not indicative of its true yield due to expected dividend cuts and losses as companies reeled from the global-lockdown recession. Although SDIV did rise for a while after that article was published, it has lost 25% of its value since adjusted to 6% after dividends. Like the global economy, SDIV is experiencing a "double dip" drawdown; however, I believe it is better described as a "dip" followed by a prolonged negative trend. The fund has closely tracked the US ISM PMI index and the US yield curve. See below:

Although only ~29% of SDIV's assets are US-based , its performance is closely tied to the overall US economy since virtually all global economies are highly US-dependent. Historically ( 1 , 2 ), the yield curve and the US manufacturing PMI are stellar economic indicators. I believe the yield curve is a better indicator of prolonged fundamental economic changes, while the manufacturing PMI measures quicker cyclical economic changes. With the yield curve as inverted as it is, more significant interest rate cuts are expected over the next decade. Investors are dramatically discounting longer-term bonds, so bond investors do not anticipate strong economic performance for years to come. On the other hand, with the PMI below 50, most US manufacturing businesses are cutting-back today.

SDIV's peak in 2021 coincided with the rise in these indicators, but SDIV may not reach a trough even if the indicators do. With the US and global economy in a strained environment, many companies in SDIV will likely see earnings slide over the coming year or years. Indeed, SDIV has faced this issue even in more substantial economic periods. Since its inception, SDIV has lost 64% of its value, or 20%, after accounting for dividends. SDIV's dividend has also fallen by around 36% due to significant dividend cuts from many of its constituents. Even in 2013-2019, the ETF struggled to deliver consistent positive returns, mainly due to companies' abysmal quality, making it among the fewer ETFs that deliver negative alpha with relative consistency.

In my view, the core issue with SDIV is that it is strongly biased toward companies making poor financial decisions. Its "strategy" is to buy the highest dividend-yielding stocks worldwide, with relatively few quality measures beyond liquidity. In general, these are beaten-down companies that trade at low "P/E" ratios; SDIV's current weighted average "P/E" is only 6.5X . The most extensive sector exposure is financials and real estate (around 50% of its assets ), which utilize greater leverage and have more cyclical exposure, particularly those with the highest yields like mortgage REITs. Further, around 21% of its assets are situated in China (Hong Kong or mainland), which, in my experience, carries more significant risks due to weaker transparency in China's financial system and political pressures. Hence, most Chinese stocks, particularly financial ones, have gone nowhere for decades.

In theory, ultra-low valuation companies can be great investments, particularly during economic recoveries. However, SDIV disproportionately invests in battered-down companies that still pay significant dividends. In most cases, it is unwise for financially struggling companies to pay high dividends, as that will often exacerbate balance sheet issues. Further, investors may be disproportionately attracted to companies with 10%+ dividend yields, causing them to become overvalued despite their high business risks.

The Bottom Line

SDIV is a chronic underperformer among high-dividend ETFs. In my view, this is due to the inherent selection bias of ultra-high dividend stocks, causing the ETF to own companies making jeopardizing business decisions. Put simply, most companies that trade at "P/E" ratios below 7X are not usually in a sufficiently healthy financial position to pay high dividends. Hence, SDIV's constituents tend to reduce their dividends over time and decline in value. Although SDIV's high yield can make up for its depreciation, it usually fails to do so. Further, in the current economic environment, I believe SDIV's constituents are likely to cut their dividends and depreciate faster than usual.

SDIV's TTM yield is 14.3%, but its SEC yield (or net yield based on most recent dividends) is 11.6% due to recent dividend cuts. Considering its constituents tend to cut dividends (particularly under economic strain), today's investors in SDIV will likely receive a yield below 11.6% over the next year. Historically, SDIV is a chronically poor investment, probably due to its selection bias, but so I generally believe investors should avoid the fund; however, I am particularly bearish on SDIV today because I think the "stagflationary" and "high-interest rate" economic environment should create excess strain for the riskiest financial and real estate stocks - which SDIV is highly exposed to. Over the next twelve months, I suspect many of those companies will experience substantial earnings declines and potential solvency issues, particularly those situated in more opaque markets like China and Brazil (14% of SDIV's assets).

Better Alternatives to SDIV

Investors interested in high-yielding ETFs may find better luck in specific sectors that pay strong yields with less risk exposure. In my opinion, US energy infrastructure companies, such as those in the ETF AMLP , are a better bet today. AMLP's dividend is closer to 8% today and has risen with the fund, but some energy MLPs do pay dividends over 10%. While this industry is historically risky, I believe the recent stabilization of the US energy sector's growth should lead to decent support and lower volatility for years. Of course, with interest rates as high as they are, short-term 1-5 year investment grade corporate bonds, such as those i n IGSB m ay offer superior risk-for-reward.

Fundamentally, with interest rates as high as they are on low-risk investments, high-risk dividend stocks are comparatively weak investments, particularly considering many of SDIV's constituents are likely seeing cash flows slip due to higher interest payments. For example, following recent rate hikes, the short-term corporate bond ETF ((IGSB)) pays a yield is over 5% today , and it carries relatively low credit risk and less interest rate risk now that the Fed's discount rate is peaking. With the yield curve near record-inversion, I believe income-seeking investors should take advantage of (much) lower-risk moderate-yield opportunities at the short end of the bond curve.

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