SCHD: Strong Dividend Yields Are The Key

| About: Schwab U.S. (SCHD)

Summary

While I positioned my portfolio in a fairly defensive manner, SCHD is one of the domestic equity funds I kept.

SCHD serves as a replacement for traditional equity indexes by offering investors a diversified portfolio with a defensive tilt.

The companies may be more exposed to pressure from increasing rates because investors are looking for yield, but they are stronger against recessionary pressures.

The Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD) is still my preferred way of investing in the domestic equity indexes and retains a more defensive portfolio allocation than the S&P 500. However, there is one downside. SCHD has a little bit more exposure to interest rate risk because a lot of these companies are Dividend Champions. Due to the importance of the dividends, they are occasionally treated as bond substitutes by investors. That can cause them to move up and down a little bit more when there are concerns about interest rates moving higher or lower.

Sector Allocation

Consumer staples are heavily overweight in the portfolio of SCHD. That is a fairly appealing characteristic if investors believe that we are late in the economic cycle. My view is that this bull market ran for quite a while and the gains to income from wages haven't kept up with where they should be for how far the market rallied. Gains to corporate earnings have been heavily strengthened by weaker bargaining power from labor and lower growth in wages.

If household income does not increase, it will be hard for consumption to increase. To be fair, household income has increased substantially at the top of the income pyramid but it hasn't increased enough in the middle and lower ranks of the pyramid. That's not an assessment over what's right or wrong, it is simply recognizing income gains at the top of the pyramid are less likely to lead to additional sales. Instead, more of that money is going to be reinvested into financial assets or simply held as cash. If those financial assets, such as bonds, were financing capital expenditures rather than stock buybacks, there would be a strong case for GDP growth to follow.

In theory, investments should drive increases in GDP. Every economic textbook can tell you that the savings rate in the economy is critical to the growth rate of GDP. The challenge for growing GDP in this environment is the marginal return on financial assets doesn't appear to be that high. You can see that in the bond markets with the exceptionally low yields on treasuries, Triple-A rated debt, and even some Double-A rated debt. Investors are recognizing that they cannot get the same return on financial capital they could get in previous periods.

Due to the low yields on bonds investors are increasingly turning to equity portfolios to create income. Consequently it's not surprising that many companies are trading at higher P/E ratios. However, investors should be concerned that corporate profits are not continuing to climb across the broad economy. If investors believe that their long term returns will be roughly equal to the earnings yield plus the growth rate in earnings, then a very weak (occasionally negative) growth rate in earnings combined with a weak earnings yield should be scary.

Intel

Looking through the top of the holdings, I see several companies that should be familiar to dividend investors. The first company on the list is Intel (NASDAQ:INTC). I don't spend much time talking about Intel, but I do see a decent future for them. Despite making hardware parts that the user may not see directly, Intel still adds value to the brands that use their products. When I bought a laptop few weeks ago, one of the things I was looking for Intel processor.

Since Intel trades at a lower P/E ratio than most of the market, 18.2x, it looks like a potential bargain. I'll let the tech guys get deeper into the Intel analysis and just enjoy the 2.76% yield.

Microsoft

Microsoft is the second holding, which is a bit troubling for me. Microsoft products concern me it's because I don't like the way they've gone with their Windows 10 release. I don't agree with the CEO about the concept of advertising being appropriate in a desktop computer. I certainly don't think it's reasonable to have the advertising that cannot be turned off in the professional license of the software. (Note: I was also specifically looking for a laptop running Windows 7 so I would know all the hardware was supported by drivers that ran on Windows 7.) I could understand why they would put that kind of advertising in the home version of the software. It seems like a creative way to subsidize the cost of the software for users that are focused on the upfront purchase price rather than on the long-term use of the product. In some cases you might even find the advertisements helpful. I wouldn't bet on that for business consumers, so it doesn't make sense to force advertisements on them.

If they're willing to pay a premium for the product, I think Microsoft should be happy about collecting the premium price. This new strategy seems like it could endanger Microsoft's dominance of the operating system environment. If there's one thing that really concerns me about Microsoft's ability to keep customers coming back when they've chosen strategies to alienate them, it is the presence of Google (NASDAQ:GOOG). I tried to using a Surface 3 (on Windows 8.1) for composing articles. My hope was that the voice recognition features would allow me to dictate entire articles. Despite training their program to recognize my voice, it wasn't accurate enough and intuitive enough for me to use.

On the other hand, this article was dictated through an Android device. Yes, it requires some edits (made from the laptop using Word), but Google's system worked better and required no time to setup. I wouldn't be surprised if this strategy backfires and Microsoft loses their monopoly on operating systems.

Chevron and Exxon Mobil

Chevron (NYSE:CVX) and Exxon Mobil (NYSE:XOM) are usually great companies for a portfolio. It stands to reason that oil should have a negative correlation with the domestic equity market. Unfortunately, that hasn't been the case so far in 2015 and 2016. As oil prices tanked late last year the correlation between oil and the domestic Equity markets turned positive. To be fair when oil prices are exceptionally low, it creates a risk to the banking sector due to smaller companies in the oil sector using excessive leverage and at risk for bankruptcies that could ripple throughout the economy. Negative correlation between oil and the domestic economy only exists when oil prices are exceptionally high. At high prices there's less risk of bankruptcy for the leveraged companies producing oil but the impact of high oil prices drives down consumer spending in other sectors.

Coca-Cola and Altria Group

Next on the list are Coca-Cola (NYSE:KO) and Altria Group (NYSE:MO). For Altria Group, the products are as addictive as the dividends. I don't choose to smoke, but I do choose to collect dividends. The thing that concerns me with Coca-Cola is the risk of regulation. While tobacco has been fighting regulation extensively for decades, sugary soft drinks have less of a history of fighting regulation and have substantial health risks of their own. It wouldn't surprise me if more taxes came out specifically targeting soft drinks.

I recently pointed out that Altria Group was approaching sale prices. While a sale on a pack of smokes wouldn't be good for your health, a sale on a dividend champion is great for the future of the portfolio.

Conclusion

The expense ratio of .07% is exceptional. The dividend yield is about as high as you'll find for a domestic equity fund that isn't filled with speculative investments or preferred shares. This portfolio is filled with the dividend champions. The risks to the portfolio are twofold. The first risk is that the domestic Equity indexes decline substantially due to falling earnings and increased fear about the future of the economy. In that case, SCHD should hold up against the losses a little better.

The second risk still involves correlation to the domestic Equity markets but it also emphasizes the importance of Treasury yields. If Treasury rates move materially higher, it could decrease the importance of holding dividend champions in the portfolio for some investors. Consequently, if the markets are declining due to fears about interest rates, the more defensive portfolio of SCHD wouldn't offer the same protection it would against fear of weak economic growth.

At current prices, I'm neither optimistic enough to add more nor inclined to sell my position. Throughout the last few months, I substantially reduced my exposure to domestic equity by selling off mutual fund positions.

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

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.

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