SCHD - Selecting Dividend Aristocrats Using SCHD's Methodology

Summary

• SCHD is one of the most popular dividend ETFs with over $37 billion in AUM.
• The fund tracks the Dow Jones US Dividend 100 Index.
• I propose leveraging the stock selection criteria from the underlying index of SCHD to build a portfolio with a subset of Dividend Aristocrats.

Schwab's U.S. Dividend Equity Fund

Schwab's U.S. Dividend Equity Fund ( SCHD ) is one of the most popular dividend ETFs on the market. The fund offers an attractive dividend yield of about 3.7%, has a history of above average dividend growth and a long-term total return that rivals the S&P 500. Did I mention its expose ratio is just 6 basis points. What more could a dividend investor ask for?

If you look under the hood of SCHD you will find that the fund tracks the Dow Jones US Dividend 100 index, that is designed to measure the performance of high yielding U.S. stocks with consistent dividend histories. What I propose is borrowing the stock selection process of the index and applying it to the dividend aristocrat universe of stocks with the intention of generating alpha. To do this we must first understand how the US Dividend 100 Index works.

Dow Jones US Dividend 100 Index

The methodology of the US Dividend 100 Index is quite simple to understand and duplicate. Here is a link to the methodology from S&P Global website the US Dividend 100 methodology can be found on page 19. H ere is a brief explanation of how it works.

The index uses the Dow Jones US Broad Market Index, excluding REITs, as its universe of stocks. As of September 30, 2022, there were 2524 constituents in the US Broad Market Index. The US Dividend 100 index applies 3 screeners as its initial filter to bring this large list of stocks to a manageable number. They are:

1. Minimum 10 consecutive years of dividend payments.
2. Minimum Float Adjusted Market Capitalization of US$500 million.
3. Minimum three-month Average Daily Volume of Trading of US$2 million.

These 3 screeners alone trim the universe of stocks down from 2524 to just a few hundred. The next step is to sort all of the passing stocks in descending order by IAD yield (Indicated Annual Dividend) not including any special dividends. The top half of stocks based on this ranking are considered for selection.

The measurement date for the dividend history is the last business day of December. While the float-adjusted market cap and the average daily volume of trading are measured as of the last business day of February.

Next, each of the eligible stocks is ranked based on the following 4 criteria.

1. Free cash flow to total debt, defined as annual net cash flow from operating activities divided by total debt. Companies with no debt are ranked first.
2. Return on equity, defined as annual net income divided by total shareholders' equity.
3. IAD yield
4. 5-year dividend growth rate, defined as the dividend rate for the prior year divided by the average dividend rate for the prior 5 years, minus one.

The 4 rankings are equal weighted and combined into a composite score that is used to rank all of the eligible stocks.

The top 100 ranked stocks are selected to be part of the index with the following 3 buffer rules.

1. Constituent stocks will remain in the index so long as they rank in the top 200 based on composite score.
2. Non-constituent stocks are added to the index until the constituent count reaches 100.
3. If two non-constituent stocks have the same composite score, the stock with the higher IAD yield will be selected first.

The reference date for all of the criteria is the last business day of December with the exception of the IAD yield that is computed on the last business day of February.

The index is weighted quarterly using a capped float-adjusted market capitalization method. No constituent can have an allocation greater than 4% and no sector weight can exceed 25%.

A daily weight cap check is performed to determine whether the index needs to be rebalanced. If the sum of the stocks with weights higher than 4.7% exceeds 22%, the index is re-weighted. The re-weighing takes place two business days after a breach, using the quarterly weighing method.

Dividend Aristocrats

The Dividend Aristocrats are an elite group of stocks with a history of long and strong dividend growth. They make excellent core additions to any dividend portfolio, offering safety and stability during all market periods. However, not all dividend aristocrats are equal, while they all have sustained periods of at least 25 years of consecutive dividend growth, some continue to grow faster than others. I already track and publish one method of selecting the best dividend aristocrats here on seeking alpha, based on dividend yield theory and projected future earnings per share. What I propose now is another method of selecting the best dividend aristocrats, borrowing the methodology from SCHD, or rather its underlying index.

I took the set of 4 criteria used to rank eligible stocks for the Dow Jones US Dividend 100 index and applied them to the dividend aristocrats to see which aristocrats would rank the best.

All of the data necessary to run this stock selection process can be found here on seeking alpha. The only exception is that you cannot find the free cash flow to total debt ratio directly, it has to be self-computed using two separate figures. Here is how all 64 dividend aristocrats ranked as of October 14, 2022.

The above table shows the value for each of the 4 criteria used for the rankings as well as the combined composite score. A lower composite score is preferable. The 5-year dividend growth rate used for this analysis is the rate reported by seeking alpha and not computed as defined by the Dow Jones US Dividend 100 index.

Additionally, Lowe's ( LOW ) and McDonald's ( MCD ) do not have a return on equity figure as both companies have negative shareholder's equity.

My Intentions for This Stock Selection Process

What I intend to do with this information is to track an index of my own, using a similar process as the one laid out in the methodology of the US Dividend 100 index. I will select a subset of dividend aristocrats annually and apply a similar capped float-adjusted market capitalization method to determine their weights. My initial idea is to select the top 30 dividend aristocrats and use a cap greater than the US Dividend 100 index. I will use twice the equal weight allocation which would be 6.67% if 30 aristocrats are selected. I will not apply any cap to sector allocation and forego the daily weight cap checks. The index will be created on January 1st 2023 and rebalanced on an annual basis.

The primary objective will be to generate a total rate of return better than the ProShares S&P 500 Dividend Aristocrats ETF ( NOBL ). I will also track this index against Schwab's U.S. Dividend Equity ETF to compare how it performs.

I will likely document this index here on Seeking Alpha starting sometime in quarter 1 of 2023. Alternatively you can find more content related to this index on my YouTube channel, link in my bio.

For further details see: