2024-01-04 23:55:29 ET
Summary
- SCHD has the best combination of quality, dividend yield, and dividend growth among nearly 1,000 U.S. Equity ETFs I analyze. But 2022-2023 was disappointing, and SCHD became a bottom-quartile performer.
- The primary reason was weak growth, and that might not change soon. Earnings revisions are relatively weak, and my evaluation across the ETF universe indicate analysts still favor growth stocks.
- Still, SCHD is a long-term hold because it's a high-quality fund. Its market-cap weighting scheme drives this, as does its quality and dividend-based composite score.
- This article walks you through SCHD's selection process, discusses the purpose of each screen. You'll also learn the reasons for why stocks are added and deleted from its Index, and what to expect when it reconstitutes again in March.
Investment Thesis
The following article reiterates my October 2023 buy rating on the Schwab U.S. Dividend Equity ETF ( SCHD ), a rare product consistently holding high-quality U.S. stocks with high dividend yields and dividend growth rates. Only a handful of ETFs come close to sharing these qualities, and it's worth buying for the long term despite its disappointing showing in 2023. However, I will also discuss why SCHD has struggled lately, as that will help you choose suitable complementary holdings. Throughout this article, I will take a fundamentals-based approach to assess SCHD alongside other funds to identify its weak spots and suggest ways to hedge your bets if it doesn't rebound in 2024. I hope you enjoy the review.
SCHD: Year In Review, Current State
In 2023, the SPDR S&P 500 ETF ( SPY ) gained 26.19%. SCHD gained 4.57% (with reinvested dividends), leading some to wonder if rules-based strategies are worth the effort. If income isn't one of your investment objectives and you're more of a growth-oriented investor, it's a fair conclusion I support. One theme you'll find throughout this article is my emphasis on quality, and there is no doubt SPY is a high-quality ETF. Surprisingly, SPY and SCHD share some similarities in how they achieve that - more on the later.
SCHD's underperforming year somehow seems worse when comparing it to other ETFs in its category. That gain ranked just #44/63 among dividend ETFs I track and was disappointing after a 3.23% decline the previous year. Barely breaking even by collecting quarterly dividends isn't exactly what SCHD investors had in mind two years ago, but here's the truth. Between 2022 and 2023, SCHD was a bottom-quartile performer (#47/60). The Fidelity High Dividend ETF ( FDVV ) and the iShares Core High Dividend ETF ( HDV ) proved superior with 13.09% and 8.92% gains. In addition, investors looking for a dividend ETF that has outperformed SPY over the last decade can consider the WisdomTree U.S. Dividend Growth ETF ( DGRW ). With an 11.13% total return, it's maintained its lead, even with minimal exposure to the Magnificent Seven.
Each month, I load monthly returns into my ETF Database and check out the winners and losers in each category over multiple periods (1Y, 3Y, 5Y, 10Y). I'm not used to seeing SCHD alongside other ETFs I've never rated a buy, like the Invesco S&P 500 High Dividend Low Volatility ETF ( SPHD ), the Global X SuperDividend U.S. ETF ( DIV ), and ProShares S&P 500 Dividend Aristocrats ETF ( NOBL ). But here we are, with SCHD's 0.59% two-year gain at the same level as SPHD and NOBL and only a few percentage points better than DIV, by far the worst-performing dividend ETF in the last ten years (28.40% total return, including dividends ).
But I've assigned a buy rating to SCHD several times, most recently in October 2023, and there are good reasons for this. Importantly, my reasons have little to do with SCHD's five- and ten-year track records, which rank #6/52 and #2/24. Instead, my approach is fundamentals-based, and I'm encouraged that SCHD is consistently a high-quality fund, indicating a turnaround is likely. I've documented the long-term success of profitable vs. unprofitable stocks numerous times, including in one review of the ARK Innovation ETF ( ARKK ). The article, titled " ARK Innovation ETF: The Plot Thins " discusses how Cathie Wood's strategy isn't difficult to figure out. Words like "thematic," "next-gen," and "transformational" are thrown around, but at the end of the day, ARKK is a basket of low or non-profitable stocks that perform well when market sentiment is positive and collapse when the euphoria wears off (usually within one or two years).
SCHD is not like ARKK, and it's also a higher-quality fund than SPHD, DIV, and NOBL. To illustrate, here's a quick snapshot of the four dividend funds, using the latest weightings (sourced directly from the provider) and fundamentals (sourced from Seeking Alpha) as of January 3, 2024.
Note SCHD's 9.37/10 profit score, which ranks #7/63, and how it nicely accompanies its 3.47% trailing dividend yield and double-digit historical dividend growth rate. The underlying metrics supporting that score include weighted average gross profit and free cash flow margins of 50.67% and 16.33%, each much better than most peers. SCHD's ROA, ROE, and ROTC figures are also terrific, and for a dividend growth ETF, it's essential companies have some extra wiggle room in the form of consistent profits. As is clear to everyone now, not every year will be a great one. Put differently, you don't want to own companies that increase dividends when they can't afford it.
Still, we must learn what went wrong last year. I've been sounding the alarm for some time, but I'm convinced it's due to SCHD's poor growth rates. That becomes evident when comparing SCHD against DGRW, the SPDR S&P 500 ETF ( SPY ), and the Vanguard Dividend Appreciation ETF ( VIG ).
SCHD's constituents had a weighted average sales decline of 2.36% over the last twelve months, and sales growth projections are only 4.08% for the year ahead. Trailing EBITDA and EPS growth was -6.04% and -5.73%, contributing to a 3.53/10 Growth Score that ranks just #52/63 and is far behind its trailing three-year rates. It's no surprise SCHD did poorly in a growth-favored market, so for SCHD to succeed in 2024, I believe it requires one of two things:
- A rotation to value, where investors would likely favor SCHD's eight-point discount on forward earnings to SPY (19.44x vs. 27.23x).
- Earnings growth, which also supports dividend growth, improves.
Until either happens, it's prudent to consider SCHD as just one part of your dividend portfolio rather than "the only dividend ETF you'll ever need," as I've seen claimed elsewhere. VIG and DGRW have growth rates between SCHD and SPY, representing a better compromise. If you're not convinced the bull market is over, consider adding growth-oriented ETFs like the Invesco QQQ ETF ( QQQ ), the Schwab U.S. Large Cap Growth ETF ( SCHG ), or the SPDR S&P 500 Growth ETF ( SPYG ). SPYG is interesting, as its Index reconstituted to close out 2023. Due to its momentum screen, the Magnificent Seven now dominate the fund's top ten holdings. In contrast and as predicted here , Microsoft ( MSFT ), Amazon ( AMZN ), and Meta Platforms ( META ) exited the SPDR S&P 500 Value ETF ( SPYV ) altogether, dropping its forward P/E to just 20.67x and in line with ETFs like SCHD.
Why SCHD Works For The Long-Term
SCHD investors are primarily interested in dividend yield, dividend growth, and value. They even like the opportunity to move away from Magnificent Seven stocks while retaining quality. SCHD excels on all of these objectives, and it's not by luck. Let's go over the selection process and what each screen does.
SCHD tracks the Dow Jones U.S. Dividend 100 Index, initially screening for U.S. securities (excluding REITs) that have paid dividends for ten consecutive years, have a minimum float-adjusted market cap of $500 million, and a minimum three-month average daily trading volume of $2 million. With only dividend-payers eligible, this screens out mega-cap stocks like:
- Alphabet ( GOOGL )
- Amazon ( AMZN )
- Meta Platforms ( META )
- Tesla ( TSLA )
- Berkshire Hathaway (BRK.B)
Apple ( AAPL ), Microsoft ( MSFT ), and Nvidia ( NVDA ) each meet the ten-year requirement, but they are quickly eliminated at the next step, where only the top 50% of remaining securities by yield qualify. To understand what that means, consider these statistics based on the information I gathered for 2,189 securities meeting the Index's sector, market cap, and liquidity requirements.
- 1,212 (55%) pay a dividend
- 727 (33%) have paid a dividend for 10+ consecutive years
Among the 727 securities left, the median (50th percentile) yield is 2.38%. That means Apple, Microsoft, and Nvidia, with yields of 0.65%, 0.91%, and 0.03%, won't qualify for the foreseeable future. As a check, I looked at SCHD's holdings with yields below 2.38%, and there were only 12, with most easily explained. Broadcom ( AVGO ), SCHD's top holding, will likely be deleted when the Index reconstitutes in March, as its 90% one-year gain has driven the stock's yield down to 1.93%. Illinois Tool Works ( ITW ), Fastenal ( FAST ), Automatic Data Processing ( ADP ), and even Home Depot ( HD ) are also on the chopping block, with yields between 2.15% and 2.42%. These removals don't mean they're poor-quality stocks. Instead, they would reflect price action over the last year. Effectively, the annual process guarantees an above-average yield and almost guarantees no growth stocks, which don't typically pay above-average dividends.
The next step involves equal-ranking the remaining securities by four fundamental factors to create a composite score, as follows:
- free cash flow to total debt
- return on equity
- indicated dividend yield
- five-year dividend growth
The first two metrics are quality-focused, while the last two are dividend-focused. Only the top 100 qualify, but existing members ranking inside the top 200 remain in the Index. This rule limits turnover, so annual additions and deletions are often yield-driven.
The final point worth discussing is the impact of the Index's weighting scheme. According to the Index methodology document , stocks are weighted quarterly based on a capped FMC-weighted approach, with no single stock representing more than 4% of the Index and no single GICS sector more than 25%. The Index is also subject to a daily weight cap check, where a re-weighting occurs if the sum of stocks with weights greater than 4.70% exceeds 22%. In my experience, this rule has yet to be implemented recently, but the float-adjusted market-cap approach has tremendous consequences. To illustrate, the highest-yielding stock in SCHD is Altria Group ( MO ) at 9.43%, but its $73.5 billion size means its weight is only 2.22%. Western Union ( WU ) and Leggett & Platt ( LEG ) are more extreme examples with yields of 7.75% and 6.97% but only 0.14% and 0.11% weights. As offsets, Broadcom and Home Depot, which barely qualified due to the yield screen, are the top holdings due to their $501 billion and $343 billion market caps.
Yield investors might not like how this all nets out, as SCHD's trailing yield is still below the yields on short-term treasuries. However, I like the approach. Markets are at least somewhat efficient, and it's no coincidence that the most profitable companies have risen to the top. Consider how the S&P 500 Index is segmented based on average profit score:
- Stocks 1-50: 9.94/10
- Stocks 51-100: 8.94/10
- Stocks 101-150: 9.39/10
- Stocks 151-200: 8.89/10
- Stocks 201-250: 8.17/10
- Stocks 251-300: 8.17/10
- Stocks 301-350: 7.59/10
- Stocks 351-400: 7.66/10
- Stocks 401-450: 7.37/10
- Stocks 451-500: 7.08/10
The correlation between size and profit score is strong except for a blip for stocks 51-100. That's why if you're looking to keep quality high, market-cap-weighting schemes are the best, and that's the main similarity between SCHD and SPY. It also explains why so many rules-based ETFs underperform the market. Managers can devise countless ways to screen for high-potential stocks, but if they fail to prioritize quality in some manner, the strategy has a high risk of failure.
Once again, a key reason why quality is not an issue for SCHD is its weighting scheme. My calculations show that if the Index were yield-weighted, SCHD's profit score would drop to 7.44/10, so its weighting scheme is crucial to its success. What makes SCHD special is that it also manages to score well on dividend yield and dividend growth. There aren't many ETFs like it, and to demonstrate, I screened my ETF Database for ETFs whose constituents have profit scores above 9.00/10, gross dividend yields above 3.00%, and five-year dividend growth rates close to 10%. Only the iShares Core Dividend ETF ( DIVB ) came close with a 9.08 / 3.13% / 9.07% slash line. Another honorable mention is the Fidelity High Dividend ETF ( FDVV ) at 9.37 / 2.97% / 7.57%.
SCHD Analysis
Snapshot By Company
Next, I want to summarize SCHD's fundamentals for its top 25 holdings, as this should help us understand its strengths and weaknesses. Metrics for four alternative ETFs are in the bottom rows, and please feel free to request additional comparisons in the comments.
I've ordered the ETFs in descending order by gross dividend yield, with SCHD's 3.64% (3.58% net) the highest and QQQ's 0.82% (0.62% net) the lowest. As mentioned earlier, DIVB offers an attractive combination of quality, yield, and dividend growth, but the fund's past performance is largely irrelevant. Its Index underwent an "exceptional" reconstitution to close in 2022, substantially changing the fund's composition.
As we progress down the list of ETFs, we generally see an increase in valuation (forward P/E), size (market cap), growth (sales and earnings per share), and earnings momentum, as measured by the EPS Revision Score. This last metric is concerning, as it suggests Wall Street is not yet bullish on SCHD's holdings. This might change when the Index reconstitutes in March, but for now, the hope is that market sentiment, in general, will turn to favor value. One example of a stock that's turned it around on EPS Revisions is AbbVie ( ABBV ). Its EPS Revisions Grade has improved from "D-" to "B," and its share price has increased accordingly. Of course, it's just one stock, and SCHD's net score is relatively poor, so I need the gap with SPY to narrow before I can confidently state value stocks are back in fashion.
From a growth perspective, AbbVie remains problematic, as does Texas Instruments ( TXN ), Verizon Communications ( VZ ), Pfizer ( PFE ), and United Parcel Service ( UPS ). Their yields are great, but it's at the expense of growth. In my view, it's a big compromise, and I wouldn't mind seeing a few exit.
Don't Forget: Annual Reconstitution Is Coming Up
On that note, I want to remind readers that SCHD's annual reconstitution is coming soon, with a new portfolio taking effect on or around March 18, 2024. The yield screen is performed using February month-end prices, so while I can't make any precise calculations, it does look like Broadcom, Illinois Tool Works, and Fastenal are on their way out. As offsets, I see Johnson & Johnson ( JNJ ) and Procter & Gamble potentially returning with the 4% maximum weighting. Exxon Mobil ( XOM ) routinely satisfies the yield criteria, but its poor 2.64% five-year dividend growth rate is one reason why it's been excluded since 2021. Still, these three stocks would make the ETF even more concentrated and increase the need for a complementary holding.
Investment Recommendation
I have a favorable view of SCHD because it trades at an eight-point discount on forward earnings to SPY, it consistently has a high profit score without any Magnificent Seven exposure, and it's one of only a handful of funds that keeps this quality while featuring a high dividend yield and high dividend growth rate. Past performance aside, SCHD is a unique offering, and I think most dividend investors can find a spot for it in their portfolios.
Nevertheless, SCHD's growth problems remain. Based on earnings revisions, growth stocks are still in control, and there is a risk of substantial underperformance in 2024 if that does not change. Still, I'm confident it will to some degree, as high-quality stocks of any style typically do not underperform the market for long. Therefore, I'd like to reiterate my buy rating on SCHD. I hope you found this article helpful, and if you would like more information on other ETFs you're considering, please leave a comment below.
For further details see:
SCHD: 2023 Was Tough, But This High-Quality Dividend Fund Should Rebound In 2024