SDVY - SDVY: Defending The Bullish Thesis After Soft Performance

2023-10-16 12:36:23 ET

Summary

• SDVY has been mostly a disappointment since the previous note as 80 holdings out of 100 in its portfolio have delivered negative price returns.
• However, I remain constructive on this vehicle nonetheless and maintain the Buy rating as the factor story remains attractive tactically.
• SDVY has both quality and value, sporting a low P/E of just 8.7x, a solid debt-adjusted earnings yield of 11.8%, and double-digit capital efficiency indicators.
• Risks and disadvantages mainly include a 60 bps expense ratio, small dividend yield, and weak growth characteristics.

Since July, stocks have been through the wringer, with the reinvigorated inflation debate and its repercussions being the top culprit. Unfortunately, the First Trust SMID Cap Rising Dividend Achievers ETF ( SDVY ) has not been unscathed. Even worse, the ETF I rated a Buy back in July has underperformed the S&P 500. This begs an update. So, today's note is supposed to:

• identify the most likely reasons for underperformance (i.e., certain stocks that were the major detractors),
• review the current portfolio in order to check how the factor story has evolved, if evolved at all (the portfolio should remain comparatively homogeneous over time since its underlying index is reconstituted only once a year in March, as per data from the index provider),
• explain why I remain constructive on the vehicle, with a Buy rating maintained.

Recapping the strategy

In a nutshell, the cornerstone of SDVY's investment strategy is the Nasdaq US Small Mid Cap Rising Dividend Achievers™ Index. The fund's website has the following brief description:

The Index is composed of the securities of 100 small and mid cap companies with a history of raising their dividends and exhibit the characteristics to continue to do so in the future ("Index Securities"). The Index is designed to provide access to a portfolio of small and mid capitalization income producing securities.

To qualify for inclusion, a company must meet a few liquidity, market cap, dividend growth, and quality criteria, including, for instance, a Cash/Debt ratio exceeding 25%. I recommend reading the prospectus for a better understanding of the process.

Finding the most likely reasons for underperformance

For now, alas, SDVY has not lived up to expectations, as its total return since the previous bullish article was published has been negative 8.15%, which is a disappointment, especially considering the vehicle has much stronger value characteristics than, for example, the iShares Core S&P 500 ETF ( IVV ) or Schwab U.S. Mid-Cap ETF™ ( SCHM ).

What were the essential culprits? To answer that question, I have compared the prices of the respective stocks from the datasets I created using the Seeking Alpha portfolio tool and downloaded on July 29 and October 14.

For example, I found a few outliers that were primary detractors. While the median decline was around 11.9%, Medifast ( MED ), Eagle Bancorp ( EGBN ), and Louisiana-Pacific Corporation ( LPX ) fell much deeper, with each down by more than 30%.

I believe MED's decline can be explained by investors being unenthusiastic about its growth prospects amid the impact of GLP-1 weight-loss drugs on its end markets. EGBN, a regional bank, delivered soft Q2 results, with the notable reduction in deposits being especially disappointing, so this triggered an investor exodus. LPX, a building solutions provider, significantly missed on both Q2 EPS and revenue in August, which provoked a sell-off.

However, the bigger issue here is that just 20 holdings delivered gains, while 80 experienced a price decline. 13 stocks, including those mentioned, declined by more than 20% over that short period. The only industry that was entirely in the green was energy, with 10 holdings gaining from 2.6% in the case of EQT Corporation ( EQT ) to almost 49% in the case of CONSOL Energy ( CEIX ). However, their contribution was still too small; energy accounted for about 10.1% in July.

Reassessing the factor story

As of October 13, SDVY had a portfolio of 100 holdings (excluding cash), precisely like in the July version. Weights were different a bit as the index was rebalanced in September, so the key holding was CEIX instead of Zions Bancorporation, National Association ( ZION ).

Some interesting shifts in factor exposures can still be observed upon more careful inspection.

Calculated using data from Seeking Alpha and the fund

• First, we see a decline in the weighted average market cap, which is certainly explainable as the fund itself has delivered a negative total return.
• What is a bit surprising is the reduction in the EY, which now stands at ~11.5%. To identify the detractors, I compared the yields and found out that, most likely, it was driven by Jackson Financial ( JXN ) since its EY had fallen from 75% to a negative level. Among other factors is Alpha Metallurgical Resources' ( AMR ) decline in the EY from about 54% to around 30%, impacted by capital appreciation and lower profits.
• The share of stocks with a B- Quant Valuation grade or higher is now a bit lower, but 43.4% is still significant nonetheless. For instance, the WisdomTree U.S. MidCap Dividend Fund ETF ( DON ), which I have reviewed recently , has only 34%.
• At the same time, despite a small decline in the EY, the weighted average dividend yield advanced by a few bps.
• Overall, despite these minor changes, I believe the value thesis remains valid.
• Growth characteristics have become a bit softer, with both EPS and revenue growth rates declining marginally. However, a nice surprise is an improvement in the 3-year and 5-year dividend compound annual growth rates.
• Quality remains mostly solid, especially assuming we are discussing a mid-cap echelon. More specifically, even though 2.8% of the holdings now have a weak Quant Profitability rating, most still score excellently. For instance, SCHM has only a ~74.3% allocation .
• This time, I also added capital efficiency indicators like ROE and ROA for a broader context. Both are at healthy levels.

In sum, even though quality and growth have become a bit softer, I see little reason to abandon the bullish thesis as all the metrics remain in my target range.

Investor takeaway

SDVY has been mostly a disappointment since the previous note as 80 holdings out of 100 in its portfolio have delivered negative price returns and energy exposure was too small to buoy it. However, I remain constructive on this vehicle nonetheless and maintain the Buy rating as the factor story remains attractive tactically. I believe the combination of quality and value is the best choice in the current environment as inflation remains a wild card, especially amid the war in Israel, which has already contributed to the oil price amid the market tightness; more expensive oil means ripple effects for products from gasoline to petrochemicals, hence, potential headline CPI surprises, and consequently higher interest rates for longer. SDVY has both, sporting a low P/E of just 8.7x, a solid debt-adjusted earnings yield of 11.8% (EBITDA/Enterprise Value, ex-financials and real estate, as per my calculations), and double-digit capital efficiency indicators.

However, there are a few risks and disadvantages. First, a 60 bps expense ratio will be a painful detractor from its total returns over the long run. Second, its growth characteristics are rather faint. Third, with a 2.4% dividend yield , SDVY is unfortunately not a play for investors favoring sizable dividends. Fourth, there is still a risk that the market would return to the growth euphoria mode. In that case, value and value-ish stocks would likely face a period of sluggish performance as investment dollars will flow in a different direction.

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