The Schwab U.S. Dividend Equity ETF Vs. The S&P 500 Index: A Comparative Case Study

| About: Schwab U.S. (SCHD)

Summary

Performs a quantitative analysis of the "Schwab U.S. Dividend Equity ETF" using some unique free cash flow ratios.

Compares the results to the S&P 500 Index, the S&P 500 equal weighted index and the "U.S. Dividend Champions".

Allows one to practice "Capital Appreciation through Capital Preservation".

Recently, I wrote an article on Seeking Alpha called "How To Value Your Portfolio On Main Street Vs. Wall Street" that explains how our Friedrich algorithm can take any list of stocks, indices, or specific portfolios and analyze each on Main Street and Wall Street, using some unique free cash flow ratios.

Friedrich is the name given to our algorithm for analyzing companies that trade on the global stock markets. In creating Friedrich, we concentrated on analyzing each company's Main Street operations and compared those results to Wall Street's own valuation, as measured by market price. Through our Friedrich algorithm, we can analyze ten years of Balance Sheet, Income Statement, and Cash Flow Statement data for each company, all at once, and generate one our final result in seconds. Friedrich was designed to be ultra-conservative, and thus, will cut zero slack to any company under analysis and will do so with zero emotion.

In this article, we will be analyzing the Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD) and compare its results to those of the S&P 500 Index (NYSEARCA:SPY), the S&P 500 equal-weighted index (NYSEARCA:RSP), as well as the popular "U.S. Dividend Champions", which can be found at a very interesting website for dividend investors called "The DRIP Investing Resource Center" that is run by fellow Seeking Alpha contributor Dave Fish.

The following is a performance chart of the Schwab U.S. Dividend Equity ETF versus the S&P 500 Index and the S&P 500 equal-weighted index since the inception date of the Schwab U.S. Dividend Equity ETF of October 20, 2011.

From a Wall Street performance point of view, the Schwab U.S. Dividend Equity ETF has underperformed the S&P 500 Index and the S&P 500 equal-weighted index since its inception in 2011. But that does not mean it may do so in the future.

Nowhere is the above statement more obviously clear than in the charts below showing what investors in Nasdaq (NASDAQ:QQQ) witnessed during the "dot com boom and bust" market of 1997-2002. But for those unfortunate souls who were clueless as to valuation (at the time) and bought at the top, it was even worse, as it took some 15 years before they broke even again. So "when you buy" and "what you pay" is just as important as "what you buy", whether that be a stock, bond, ETF, or fund.

Since most investors hardly do any due diligence prior to investing, the combined group ends up operating through greed and fear, and no one understands this better than Warren Buffett:

In order to avoid joining the herd, it is important to continuously analyze one's holdings by measuring your portfolio's Main Street performance versus its Wall Street valuation. Whether you are a portfolio manager in charge of $1 billion in assets or a small investor with a $10,000 portfolio, the concept is always the same. You, as an investor, should always know where your portfolio stands at all times, and thus, not be swayed by groupthink. By doing so, you are always practicing "Capital Appreciation through Capital Preservation".

Well, how does one go about doing so? Before I present our final results for the Schwab U.S. Dividend Equity ETF versus the S&P 500 Index, the S&P 500 equal-weighted index, and the "U.S. Dividend Champions", let us first explain how we compare Main Street performance to Wall Street valuation. We will do so by using our Friedrich Investing System.

The Main Street ratio we use in our analysis is called FROIC, which can be defined as:

Main Street Analysis = FROIC

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) + (Capital Spending)]

* When doing our free cash flow calculation, please note that because Capital Spending is recorded in the cash flow statement as a negative result, and we therefore must add it, in order to subtract it properly.

FROIC = (Forward Free Cash Flow)/(Long-term Debt + Shareholders' Equity)

What the FROIC ratio does is tell us how much forward free cash flow the company is generating on Main Street relative to how much total capital it has employed. So, if a company invests $100 in total capital on Main Street and generates $20 in forward free cash flow, it therefore has an FROIC of 20%, which we consider excellent. This is just one of the key ratios (66 in total) we use to identify how a company is performing on Main Street, as it is our belief that if a company is making a killing on Main Street, this news will eventually show up on Wall Street's radar.

For our Wall Street Analysis, we used our Price-to-Bernhard Buffett Ratio.

Wall Street Analysis = Price-to-Bernhard Buffett FCF

Many years ago, while reading Berkshire Hathaway's (BRK.A, BRK.B) 1986 letter to shareholders, I discovered a ratio, which Mr. Buffett entitled "Owner Earnings", or what we may consider to be Mr. Buffett's version of "Free Cash Flow". To my amazement, in that little footnote, Mr. Buffett explains how to use it and basically states that it is one of the key ratios that he and Charlie Munger used in analyzing stocks. In that article, he defined the term "owner earnings" as the cash that is generated by the company's business operations.

[Owner earnings] represent [A] reported earnings plus [B] depreciation, depletion, amortization, and certain other non-cash charges... less [C] the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.

I have used this free cash flow ratio for decades, using data from the Value Line Investment Survey, whose founder was Arnold Bernhard. Mr. Bernhard was a big fan of free cash flow and probably introduced it sooner than Mr. Buffett did. I know this as I was able to calculate the FCF ratio using old Value Line's sheets for my 60-year backtest of the DJIA from 1950 to 2009.

In the backtest I mentioned above, I demonstrated that if one can purchase a company whose shares are selling for 15 times or less its Price-to-Free Cash Flow ratio, the probability of success will dramatically increase in most cases. I have renamed the ratio the Bernhard Buffett Free Cash Flow ratio in honor of both men. The following is how each ratio below is calculated:

Price-to-Bernhard Buffett Free Cash Flow Ratio = Sherlock Debt Divisor/(net income per share + depreciation per share) + (capital spending per diluted share)

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-term Debt)/Diluted Shares Outstanding)

Sherlock Debt Divisor. A major concern that I have these days in analyzing companies is the amount of debt each takes on relative to its operations, and whether management is abusing this situation by taking on more debt than it requires. Debt, when used wisely, allows for what is called leverage, and leverage can be extremely beneficial within certain parameters. On the other side of the coin, the use of debt can also be excessive and put a company's future in jeopardy. So, what I have done to determine if a company's debt policy is beneficial or abusive is to create the Sherlock Debt Divisor.

What the Divisor does is punish companies that use debt unwisely and reward those that successfully use debt as leverage. How do I do this? Well, I take a company's working capital and subtract its long-term debt. If a company has a lot more working capital than long-term debt, I reward it, and punish those whose long-term debt exceeds its working capital. So, if this result is higher than the current stock market price, then leverage is being used, and the more leveraged a company is, the worse the results of this ratio will be and the less attractive its stock will be as an investment.

Thus, having successfully defined the Sherlock Debt Divisor, I thought I would give an example of how it works by analyzing Home Depot (NYSE:HD). In order to do that, we need the following bits of financial data in order to calculate it for the Home Depot. TTM, for those who don't know, is "trailing 12 months", or as close to real time data as we can get, based on when each company reports.

  • Market Price Per Share = $143.68 (at time of analysis)
  • Working Capital = Total Current Assets - Total Current Liabilities
  • Total Current Assets = $19,348,000,000
  • Total Current Liabilities = $14,431,000,000
  • Working Capital = $4,917,000,000
  • Long-term Debt = $22,338,000,000
  • Diluted Shares Outstanding = 1,229,000,000

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-term Debt)/Diluted Shares Outstanding))

Sherlock Debt Divisor = $143.68 - (($4,917,000,000 - $22,338,000,000)/1,229,000,000))

Sherlock Debt Divisor = $143.68 - (-$14.17) = $157.85

Since Home Depot has more long-term debt versus working capital, we therefore must punish it and use the new $157.85 as our new numerator in all our calculations.

Having calculated the Sherlock Debt Divisor for Home Depot, let us now proceed and do a Price-to-Bernhard Buffett analysis for the company.

Price-to-Bernhard Buffett FCF Ratio = Sherlock Debt Divisor/ [(net income per share + depreciation per share) + (capital spending per diluted share)]

Sherlock Debt Divisor = $157.85

Net Income per diluted share = $7,684,000,000/1,229,000,000 = $6.25

Depreciation per diluted share = $1,953,000,000/1,229,000,000 = $1.59

Capital Spending per diluted share = -$1,565,000,000/1,229,000,000 = -$1.27

$6.25 + $1.59 + (-$1.27) = $6.57

Price-to-Bernhard Buffett Free Cash Flow Ratio = $157.85/$6.57= 24.03

Now that we have taught everyone how to calculate our Price-to-Bernhard Buffett Free Cash Flow ratio, let us now move on and teach everyone how to calculate our FROIC ratio, using Home Depot again as our example.

This is how we calculate it:

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) + (Capital Spending)]

FROIC = (Forward Free Cash Flow)/(Long-term Debt + Shareholders' Equity)

Net Income per diluted share = $7,684,000,000/1,229,000,000 = $6.25

Depreciation per diluted share = $1,953,000,000/1,229,000,000 = $1.59

Capital Spending per diluted share = -$1,565,000,000/1,229,000,000 = -$1.27

Revenue Growth Rate TTM = 5%

[(($6.25 + $1.59) (1.05%)) + (-$1.27) = $6.96

Long-term Debt = $22,338,000,000

Shareholders' Equity = $5,622,000,000

Diluted Shares Outstanding = 1,229,000,000

FROIC = (Forward Free Cash Flow)/(Long-term Debt + Shareholders' Equity)

$6.96/$22.75 = 31%

FROIC = 31%

Now that we have defined the ratios to be used in our analysis and have showed everyone how to calculate each of them, here is a complete analysis of the individual components of the Schwab U.S. Dividend Equity ETF:

When analyzing the Schwab U.S. Dividend Equity ETF components we set up certain rules to use when analyzing any group of stocks, which you should also follow when analyzing one's own portfolio using our methodology:

  1. If a stock has a negative FROIC result, we automatically assign it a score of 100 for its Price-to-Bernhard Buffett FCF ratio, in order to keep everything consistent and logical, as you can't have a negative Price-to-Bernhard Buffett FCF ratio when analyzing portfolios.
  2. Then, at the same time, the maximum FROIC allowed is 100%, so we can keep everything consistent and logical as well, as anything higher distorts the results for the group.
  3. We also give a zero result for FROIC for any "cash position" in the portfolio and a 22.50 result for the Price-to-Buffett Free Cash Flow, (which is 15 (buy) + 30 (sell) = 45/2 = 22.50). This was done to force one never to feel comfortable in cash, unless one has no choice in the matter, which is the case for us now. Our real-time research clearly shows that the markets are overvalued, as measured by our analysis of the S&P 500 index.

The final results for the entire the Schwab U.S. Dividend Equity ETF are:

FROIC = 17% (Main Street)

Price-to-Bernhard Buffett FCF = 28.74 (Wall Street)

The final results for the entire S&P 500 Index are:

FROIC = 12% (Main Street)

Price-to-Bernhard Buffett FCF = 38.34 (Wall Street)

The final results for the entire S&P 500 Equally Weighted Index are:

FROIC = 10% (Main Street)

Price-to-Bernhard Buffett FCF = 42.67 (Wall Street)

The "US Dividend Champions" generated the following combined average results, using an equally weighted portfolio analysis:

FROIC = 12% (Main Street)

Price-to-Bernhard Buffett FCF = 34.89 (Wall Street)

For FROIC, we consider any result above 20% to be excellent and any result above 10% to be good, so the Schwab U.S. Dividend Equity ETF, in having an FROIC of 17%, can be considered very good and tells us (that as a group on Main Street) the components of the ETF are doing well. The ETF also generated a score of 28.74 for our Price-to-Bernhard Buffett FCF ratio. That ratio considers a stock a bargain when it trades under 15 times and overbought when it trades over 30 times. Therefore, the Schwab U.S. Dividend Equity ETF is a weak hold and is approaching "overbought" territory.

Going forward, we can clearly determine from the four results we have generated above that the Schwab U.S. Dividend Equity ETF is doing the best on Main Street (performance-wise) and is the least expensive on Wall Street (from a valuation point of view).

Therefore, with three of the four results above coming in as "Overbought", it may be smart to follow the advice that Warren Buffett gave above and be "fearful" when investing these days, for if one does invest, one is doing so in an environment of "overbought conditions" on Wall Street. Investors are clearly investing with blinders on in pure greed, and in doing so, are following the immortal words of Chuck Prince (former CEO of Citigroup) prior to the S&P 500 Index's 2008-2009 collapse of -59%:

In conclusion, it is my belief that free cash flow analysis is the ultimate tool when analyzing companies, and my hope is that you may add these ratios to your own investor tool box in order to help you in your own due diligence. If you have any questions, please feel free to ask them in the comment section below, and don't forget to hit the "Follow" button next to our username at the top of this article. Now that we are able to analyze indices, we will continue the process of analyzing ETFs, mutual funds, and certain popular portfolio managers' (gurus) portfolios in a series of articles here on Seeking Alpha. That effort will, of course, be in addition to providing analysis on individual stocks. Since most use the S&P 500 Index as the comparative benchmark, we can see how each is doing in a side-by-side comparison.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.

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