DGRO - VIG: Why It's A Buy After The March 2023 Reconstitution

2023-03-23 16:53:18 ET

Summary

• The S&P U.S. Dividend Growers Index completed its multi-day rebalancing on Tuesday. Apple, Exxon Mobil, and Merck are the top three additions, with no noteworthy deletions.
• The new portfolio is superior to SPY in almost every way. VIG is less volatile, has a lower valuation, higher earnings growth, and substantially better earnings momentum.
• Investors might still opt for other low-cost ETFs like DGRO, SCHD, and VYM. I'll present their fundamentals side by side, easily highlighting the trade-offs to consider.
• This article explains why I've reversed my position on VIG. After more than a year of criticism, I believe it's worth buying again.

Investment Thesis

The S&P U.S. Dividend Growers Index completed its multi-day rebalancing process on Tuesday, resulting in 42 additions and 12 removals. This article discusses the impact on the Vanguard Dividend Appreciation ETF ( VIG ), the $65 billion fund that's tracked the Index since September 2021. The key additions were Apple ( AAPL ) and Exxon Mobil ( XOM ), and the portfolio is seen much more favorably on Wall Street compared to other popular choices like the Schwab U.S. Dividend Equity ETF ( SCHD ). Importantly, it beats the SPDR S&P 500 ETF ( SPY ) on nearly all metrics I measured, including expected earnings growth and valuation.

I downgraded VIG in November 2021, opting for high-dividend yield ETFs with better fundamentals in 2022. However, I reverse my position today and see VIG as a rare dividend fund with excellent earnings momentum worth the higher price. In short, I have decided to upgrade my recommendation to a buy, and I look forward to explaining why in further detail below.

VIG Overview

Strategy Discussion

VIG tracks the S&P U.S. Dividend Growers Index, selecting U.S. stocks of all sizes that have increased dividends for at least ten consecutive years. REITs are excluded, and the Index applies a simple liquidity screen, as shown below.

Two factors primarily drive additions and deletions. The first is the dividend growth streak, and the second is a stock's indicated dividend yield related to other eligible stocks. If a stock's dividend yield is within the top 25%, it doesn't qualify, but that figure is relaxed to 15% for current constituents. In my previous review , I noted how the Index deleted Merck & Co. ( MRK ) because its yield was inside the top 15%. However, it's back in after a solid year. It's one example of how this yield trap screen may only sometimes work in shareholders' favor.

Top Holdings

Vanguard will officially publish the weightings of the reconstituted portfolio around April 14, 2023. However, investors can access the Portfolio Composition File if they agree to its terms. In this case, I accessed it to assess the changes and assign approximate weightings to the holdings. As shown, Microsoft ( MSFT ), UnitedHealth Group ( UNH ), and Johnson & Johnson ( JNJ ) are in the top five, as are the newest additions, Apple and Exxon Mobil.

Sector Exposures

The following graph highlights sector exposures for VIG, the SPDR S&P 500 ETF ( SPY ), the iShares Core Dividend Growth ETF ( DGRO ), the Schwab U.S. Dividend Equity ETF ( SCHD ), and the Vanguard High Dividend Yield ETF ( VYM ). I consider SPY and DGRO closer comparators to VIG, while SCHD and VYM are solid higher-yielding options.

VIG's holdings are as of February 28, 2023, but Technology exposure increased from 23.59% to 26.74% post-reconstitution, while Energy rose from 0.09% to 3.36%. Financials, Consumer Discretionary, and Consumer Staples decreased by 2.49%, 1.38%, and 1.21%, respectively. It's worth mentioning that VIG's turnover is typically lower than other dividend ETFs, an excellent feature for passive investors. Most changes are yield-driven, and it's unusual for the Index to add stocks as large as Apple.

VIG Key Additions

The following table highlights the 42 additions and their returns from April 2022 to March 2023. As with SCHD, I evaluate these metrics to get a general idea of what the reconstitution accomplished. For example, deep-value high-dividend ETFs might add stocks that recently performed poorly, while momentum funds generally add the best performers. Ideally, selections are driven by more than recent price returns, so I prefer a mix.

Apple, Exxon Mobil, and Merck & Co. have current weights of 4.20%, 3.27%, and 1.98%, while the remaining 39 additions total 3.02%. Therefore, don't let the minor additions distract you. The additions are well-balanced, with Apple proving relatively resilient with a 9.06% decline and Exxon Mobil bumping up the previously zero Energy sector exposure.

VIG Key Deletions

The 12 deletions are listed below, led by Truist Financial ( TFC ), Activision Blizzard ( ATVI ), and T. Rowe Price Group ( TROW ). However, these deletions previously totaled just 1.54% in weight and are relatively immaterial.

VIG Analysis

The following table highlights selected fundamental metrics for VIG's top 25 holdings, totaling 52.60%. I've listed the same metrics for DGRO, SCHD, VYM, SPY, and VIG's portfolio pre-reconstitution to see the reconstitution impact.

The five-year betas for all dividend-oriented portfolios are around 0.90, indicating a similar level of downside protection. Given the economic uncertainties, I favor lower volatility relative to the broader market. There are many recession indicators, such as those predicted by U.S. treasury spreads. The timing is uncertain, but the probability of a recession weighing over us will likely limit equity returns. For its part, the Conference Board predicts it's a near certainty over the next twelve months.

The most recent recession probability estimates, based on our probability model, remain near 99 percent pointing to the likelihood of a recession in the US within the next 12 months. This supports our expectation of a recession to start in early 2023 and last through the third quarter largely due to the Federal Reserve's interest rate hikes. The first three quarters of 2023 are likely to see zero or negative real GDP growth rates.

Therefore, it's prudent to take some risk off the table by using dividend- and value-oriented ETFs. VIG's $362 billion weighted-average market capitalization makes it the closest comparator to SPY's $522 billion, followed by DGRO, VYM, and SCHD. Importantly, all ETFs have strong profitability grades using data derived from Seeking Alpha Factor Grades, with VIG's 9.40/10 figure slightly better than SPY's 9.36/10. These scores give me confidence in the portfolio long-term. VIG is among the safest buy-and-hold investments because of its traditionally low turnover rate.

Recognizing the risk of richly-valued stocks, I downgraded VIG to a hold in November 2021. Looking back, it was the right call. VIG was among the worst-performing dividend ETFs the following year, with DGRO, SCHD, and VYM outperforming. Still, all outpaced SPY, which declined by 18.17%.

However, the table above indicates VIG has a higher estimated earnings growth rate (8.34%) than all comparators, including SPY's 8.16%. Since VIG's 20.44x forward valuation ratio is 3.22 points less, there aren't any good reasons to choose SPY over VIG. VIG is just as profitable as SPY, and it also has a slightly higher gross dividend yield (2.05% vs. 1.67%) and a significantly better EPS Revisions Score (5.73/10 vs. 5.20/10).

The way VIG accomplishes this is two-fold. First, its 15 most overweighted securities universally beat analyst earnings expectations last quarter. Accordingly, their average EPS Revision Score is 6.05. Second, only 9/15 of VIG's most underweighted securities surpassed expectations in the previous quarter, with some missing by 10% or more. As a result, these 15 stocks have an average 5.14/10 EPS Revision Score. To understand the key differences between VIG and SPY, consider the following earnings summary table below.

One risk is if the market ignores fundamentals for an extended period. It occurred recently with stocks like Tesla ( TSLA ) gaining 60% YTD despite downward earnings revisions. These unusual periods occasionally happen, like in 2009 and 2022. However, fundamentals eventually win out, as they did in 2022. I'm more comfortable overweighting stocks that are delivering on the earnings side. The lower valuation, lower volatility, and higher earnings growth rate are a bonus.

SCHD and VYM deliver better yields, but as described here, investors should limit dividend growth expectations based on slower sales and earnings growth. DGRO is a compromise on growth, valuation, and yield. However, if you value earnings results and the opinion of Wall Street analysts, VIG is the strongest.

Investment Recommendation

After the March 2023 Index reconstitution, VIG remains less volatile than the market despite the addition of Apple and Exxon Mobil. Furthermore, VIG has more favorable profitability, growth, valuation, and yield metrics than the broader market. For readers deciding between these two ETFs, VIG is a no-brainer. Canadians can also purchase this ETF on the Toronto Stock Exchange to avoid foreign exchange fees under the ticker VGG:CA .

The choice is more complicated when deciding between VIG and other higher-yielding options like DGRO, SCHD, and VYM. These ETFs have lower valuation ratios but suffer from poor earnings momentum. It wasn't a big deal one year ago because most ETFs had scores between 6.00-6.50/10. However, the environment is different today, and I'm looking to keep this score as high as possible while maintaining sufficient diversification. Therefore, I think VIG will outperform them all as we advance and plan to provide regular updates as these key indicators change. Thank you for reading, and I look forward to the discussion in the comments section below.

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