Richard Drury
In March this year, I issued a rather pessimistic article on the Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD), recommending investors avoid going long with this ETF.
The reason was simple – the opportunity cost was just too huge relative to the other high yielding investment plays out there. In other words, by investing in SCHD, investors would have to lock in an unattractive entry yield, where even after considering the dividend growth potential, there would still be a meaningful gap between total current income streams between SCHD and some defensive high yielders.
Since the dividend income profile of SCHD was not that enticing, going long here just did not make sense, especially considering that one of the key objectives of this ETF is to satisfy yield-seeking investors. For instance, SCHD is certainly not a capital growth (price appreciation) vehicle, as it does not carry high growth names that typically distribute no or very minimal dividends.
Looking at the chart below, we can see that after the publication of my article, SCHD has lagged behind the S&P 500 (measured on a total return basis). This has to do with the point that SCHD does not put a huge emphasis on the truly high-flying stocks, which have no meaningful dividend policies in place, and thus they fall out of the investment selection process.
However, there are now two fundamental aspects that have led me to revise the thesis and form a more bullish view of SCHD.
Thesis review
The first aspect is related to the enhanced attractiveness of SCHD’s dividend yield, which as illustrated in the chart below has gone up by ~ 30 basis points. Yet, I would argue that the actual yield is higher than this if we shift the calculus from a TTM approach to an annualized FWD yield based on the collected distribution level in the most recent quarter.
By applying this kind of approach, we arrive at an implied / FWD dividend yield of ~ 4.2%, which is already an enticing level from an absolute level perspective. If we compare this yield with the U.S. 10-year YTM levels we will no longer see any meaningful difference between these two yields.
Here one could theoretically argue that it does not make sense to base the dividend estimate on the recent quarter, since over the next couple of quarters the distribution levels could sink. While it is true that the quarterly distribution levels are volatile (i.e., not growing in a linear fashion), we will not find any instance where SCHD has paid out a lower dividend in Q4 than in Q2, and it is not that often when the Q3 dividend amount comes in at a lower level than in the prior quarter.
All in all, the yield component of SCHD has indeed become attractive even if we do not take into account the element of growth, which is really the key essence of this ETF. So, what investors now effectively get is an ETF which provides a decent yield from the start with a ~ 10% dividend growth potential on a go-forward basis, where the underlying cash flows are underpinned by robust and large-cap businesses.
The second aspect, which renders SCHD an interesting ETF to consider, is the future trajectory of the interest rate levels. In the chart below we can observe two things: (1) the Fed Funds rate is set to go down from here and (2) the level of interest rates will still remain higher than where they were during the accommodative monetary policy phase.
This implies a couple of things for SCHD. The most important one is that I believe decreasing interest rates will inevitably impact growth names in a more favorable way than high-yielding assets (or businesses). This has to do with the duration factor that is more pronounced for companies that have a back-end loaded cash flow profile. For SCHD’s investments, this is the case, as most of the investments could be deemed large-cap growth names that have strong enough growth prospects to accommodate double-digit dividend growth.
Conversely, the instruments that offer abnormal yield levels now are typically the ones which do not really have solid prospects to increase their cash generation levels in the future, thereby rendering the duration factor relatively smaller than for the more growth-oriented names.
This means that once the interest rates start to drop, the likely effects on the asset prices will be more favorable to SCHD’s holdings than, say, for conventional high-yielding segments such as BDCs and MLPs.
Meanwhile, the FOMC dot plot also indicates that it is unlikely that the SOFR will converge back to zero or extremely accommodative levels, which, in turn, should put a floor on how low the dividend yield of SCHD could drop. As a result of this, we could assume that the risk of investors facing a reinvestment risk (from the perspective of low incremental yield levels on the reinvested capital) is rather distant.
The bottom line
As many of my followers have probably noticed, I am a huge fan of high-yielding instruments (with average yields of 7 – 10%), which explains circa 90% of my portfolio.
While some time ago I was relatively skeptical of SCHD – mostly from the opportunity cost perspective – the increase in SCHD’s yield coupled with a more pronounced element of capital appreciation potential that would be associated with decreasing interest rates makes me change my stance.
In my view, at this particular moment, the Schwab U.S. Dividend Equity ETF presents a compelling entry point even for high-yielding investors who are willing to consider adding some investments that offer a bit of a lower yield from the start, but also have a stronger dividend growth potential that could relatively quickly offset the foregone income potential.