A couple of dividend-focused ETFs have appeared on the site to date. These were the Vanguard High Dividend Yield ETF (VYM) and its cousin, the Vanguard International High Dividend Yield ETF (VYMI). Despite their names, they are not as crude as simply picking the highest yielding stocks out there. That said, they will always offer ‘above average’ yields due to the methodology of their indices. The index construction methodology also means their weightings will favor large-caps, the net result being a kind of blue chip value fund made up exclusively of dividend-paying stocks. I like that idea – it is zero hassle and you could make it work in a very simple three or four-fund portfolio.
On that note, we arrive at the Vanguard Dividend Appreciation ETF (VIG). This one is a slightly different, and interesting, beast. It is popular with dividend growth investors, with its name being a little bit of a giveaway there. Anyway, VIG held around $56b worth of stock at last count, so it is a pretty chunky fund. The bigger the better in my view: it increases the chances of it sticking around for a very long time, and that is exactly what buy-and-holders want to see. VIG also comes with incredibly low costs. The expense ratio stands at just 6 basis points per annum, or $6 for every $10k invested.
As the name implies, VIG invests in stocks with a history of paying growing dividends. More specifically, it aims to track the NASDAQ US Dividend Achievers Select Index. Funnily enough this index appears to exist solely for the benefit of VIG, and Vanguard notes this exclusive arrangement with NASDAQ in the fund’s policy section. This is not an issue per-se, but it is the first interesting thing to note about the fund. The second thing is the slightly opaque methodology of the underlying index. The simple part is that only stocks with ten-plus years of consecutive dividend growth are eligible, excluding REITs. The complex part is that it follows a modified market-cap weighting, with additional undisclosed selection criteria also used to determine constituents.
The upshot of the above is that it is weighted toward larger dividend growth stocks at the expense of smaller ones. Moreover, the top-ten holdings make up a really big chunk of the fund’s assets. VIG currently holds more than 210 stocks in total, but the top ten account for over one-third of assets. The undisclosed selection criteria also provides some interesting results. For instance, the fund does not seem to own any Coca-Cola stock. That cannot be due to its dividend growth record, which is well in excess of the requirements, so it must be due to the aforementioned extra selection criteria.
Let’s stick to what we absolutely do know, which is the minimum ten-year dividend growth requirement. It appears that some stocks, like Disney, fall foul of this rule right now. That is probably due to the fact that the index only evaluates its constituents once a year. It seems that dividend cutters like Disney will get the boot at the next evaluation in March. Now, this hard rule of ten-plus years of consecutive growth seems a bit too arbitrary to me. Indeed, Disney getting kicked out would provide a perfect example. There may be good reasons to sell it, but I would not say that a COVID-induced dividend cut is one of them.
With that said, rules are rules when it comes to indexing. And although it may seem arbitrary, it does throw up one interesting side-effect: it appears that the dividend growth criteria is a way to screen for quality. I mean, VIG’s 5-year average return on equity (ROE) stands at over 22%. The comparable figure for the S&P 500 is around 17.3%. If you want a large-cap quality fund, it looks like VIG offers an interesting way of getting one.
VIG has returned around 14% per annum over the past five years. Breaking that number down, it looks like around half came from underlying EPS growth. The 5-year average dividend yield of circa 2% speaks for itself, while the rest came from an expanding valuation multiple. Going back a bit further, the distribution here has compounded at circa 7.7% per year since 2007. That was the first full year after VIG’s inception back in 2006. Throw in that 2% average dividend yield, and you can see that you had the trappings of a decent investment.
VIG units closed last week at the $139.80 mark. The fund should payout circa $2.25 per unit in 2020, leading to a 1.6% dividend yield. VIG’s share of net income is currently somewhere in the $5.50 per unit region, putting the fund’s current valuation at around 25x earnings. Now, you could easily argue that higher profitability metrics deserve a higher valuation. That said, it seems sensible to discount the idea that valuation changes will continue to provide a tailwind. Indeed, I would put prospective underlying returns in the high single-digit per annum area. I base that on long-term EPS growth in the 7% per annum region, plus the current distribution yield of 1.6%. Valuation contraction could knock that down by a couple of points in terms of shareholder returns depending on your timeframe.
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