VYM Illustrates The Importance Of Dividends

| About: Vanguard High (VYM)

Summary

VYM offers a solid dividend yield of 3.13% to go with a low expense ratio and a reputable firm backing the fund.

The holdings are stacked with dividend champions.

The flattening of the yield curve leaves income investors with fewer options.

The Vanguard High Dividend Yield ETF (NYSEARCA:VYM) is a very solid ETF, though I have some concerns about domestic equity prices after the strength of the rally over the last six weeks. The flattening of the yield curve is sending income investors in search of a respectable yield. When VYM yields 3.13% and the 30 year treasury is down to 2.62%, income investors face a fairly substantial challenge.

Expenses

Investors should always check the expense ratio of an ETF prior to investing. For VYM the ratio used to be .10%, but a battle between fund advisors is driving down expenses on several quality funds. For VYM the ratio was cut to .09%.

Impact of the Yield Curve

The yield curve may not be the first thing investors are thinking about when they researching equity investments, but it is a very substantial factor. With treasury rates running about 50 basis points below the yield on VYM, investors confident that they can wait 30 years without touching their portfolio could reasonably expect superior total returns on VYM so long as the share price at the end did not decline by more than 15% and the dividend was never cut. This doesn't require a single dividend raise, it just requires an absence of cuts. If we are looking 30 years out and assume that inflation was running 2% per year, then stocks keeping up with inflation would expect to see 81% price appreciation. This is simply 1.02^30-1. Granted, if there are no dividend increases in 30 years for a portfolio built on dividend growth champions it would suggest something was dramatically wrong with the macroeconomic picture.

Sectors

The following chart demonstrates the composition of the fund by sector allocations:

Click to enlarge

I tend to prefer using terms like "consumer staples" and "discretionary" rather than goods and services, but the goods category aligns with the more defensive allocations. I see this sector as being very favorable for overweighting. In my own allocations, I materially overweight the consumer staples sector. To be more specific, I gave significant positions to Altria Group (NYSE:MO) and Phillip Morris International (NYSE:PM). As you might guess, PM and MO will show up in VYM's portfolio.

Holdings

The follow chart demonstrates the top several individual company allocations:

Click to enlarge

This is a pretty clear chart of the big dividend growth champions. I see companies in here that made their names on sustaining and growing their dividends. Cutting dividends would be a very hazardous proposal by management which encourages them to be very careful with cash flows.

With oil prices lifting off, Exxon Mobil (NYSE:XOM) looks ready to recover. Of course, XOM lost dramatically less than most oil stocks when the oil prices came crashing down. XOM's ability to withstand fluctuations in oil prices, recessions, and pretty much anything else the market has seen for decades makes it a fairly reasonable choice for oil exposure. I have the stock on my list of contenders to join my portfolio during the next year.

Wal-Mart (NYSE:WMT) and McDonald's (NYSE:MCD) both occupy spaces in the chart and I expect both to perform decently over the next several years. I strongly expect WMT to win if we compare these two dividend champions because the company simply trades at very low multiples. The announcements that they would raise wages sent shares into a tail spin and left the previously expensive dividend champion in the bargain bin as investors discarded the name. The benefit of the low share prices come from a few sources. The company has a huge buyback authorization which will be substantially more effective with the low prices and for investors that are reinvesting their dividends the share count in their portfolio will grow faster.

The allocation that strikes me as the strangest is Microsoft (NASDAQ:MSFT) at the very top of the portfolio. I have a hard time getting behind the allocation. As an analyst I usually dig into the fundamentals, but with Microsoft I see some simple problems that concern me. I am part of their key demographic. I own several desktop computers (all running Windows), as well as a Surface. I haven't been impressed with anything they produced since Windows 7.

Conclusion

If there are no dividend cuts, VYM should be able to sustain performance for long term buy and hold investors. In the short term I see some significant price risks. The fundamentals of the macroeconomic environment are not substantially stronger now than they were at the start of the year when prices were materially cheaper (around 12%).

I believe the strongest support for the rally in share prices is the weak treasury yields pushing investors into equity positions in an attempt to get some respectable yield out of their portfolio. That creates some price support for VYM, but an announcement that the Federal Reserve intended to let their longer duration positions start running off (not reinvesting) could send yields higher and put a sudden pressure on equity prices. This can be a very dangerous situation because treasury securities and domestic equity indexes usually have a negative correlation. Investors could usually buy long duration treasuries as a way to protect their portfolio against a decline in equity indexes, but whispers of a reduction in the bond position could bring bond yields back to the levels where they would be viable income options again, as they used to be.

Disclosure: I am/we are long MO, PM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.