DVY: A Few Positive Developments
Summary
- My 2018 outlook for DVY was modest, but that was before the correction.
- DVY has reduced its utilities exposure, which I view as a positive in a rising rate environment.
- DVY's dividend growth last year was impressive, and I expect 2018 to be similar.
Main Thesis
The purpose of this article is to explain why I feel the iShares Select Dividend ETF (NYSEARCA:NASDAQ:DVY) is an attractive investment option at its current market price. My outlook for dividend funds is still largely positive for the new year, as I expect dividend payouts to rise handsomely with tax reform as a major catalyst. Furthermore, DVY already has a solid tracking record of increasing its distributions, so this year should be no exception. Also positively, DVY has a slightly reduced stake to the utilities sector, since my last review, which I believe is a good thing with interest rates set to rise. Finally, DVY's second largest sector is financials, a sector I expect to out-perform the broader market in 2018.
Background
First, a little about DVY. The fund seeks to track the investment results of an index composed of relatively high dividend paying U.S. equities. The index includes companies with comparably high dividend yields that have at least a five year track record of paying dividends. DVY is currently trading at $96.46/share and its most recent dividend payment was $.80/share. Based on the last four dividend payments, it yields 3.07% annually. So far in 2018, DVY has struggled, and the fund is down close to 2.5% since my last review, when I recommended investors avoid the fund. While this is not a large drop, it is significant when you consider that the S&P 500 is up over 2% during the same time period. However, since that review, the market correction has me considering adding to more defensive positions, and I believe DVY offers investors a much better value proposition than it did just a few months ago, which I will explain in detail below.
Dividend Growth - With More To Come
One of my primary concerns with respect to dividend funds in 2018 is whether or not their yield will continue to attract income investors. This is because, as investors have been drawn to these funds over the past decade, yields have shrunk to the point where even "high yield" funds rarely exceed 3%. While DVY does exceed that threshold, the truth is a 3% yield is a low bar to set, and DVY only slightly exceeds it anyway. The logical premise would be, as the Fed raises rates throughout 2018, share prices will likely come down in many of these dividend funds, until the yield once again becomes attractive. The result could be painful for current investors until prices stabilize.
Despite this backdrop, I feel that there are dividend funds out there that still over investors some value, but it is more important now than ever to be especially critical of each fund before deploying capital. That is where DVY comes in. While I mentioned that share prices could fall to boost the yield, the other alternative is that the fund could boost its dividend payout, increasing the yield without painful capital depreciation. I am confident this scenario could occur with DVY, and its history is a powerful guide for this belief. To illustrate, I have compiled the chart below detailing DVY's dividend payouts and dividend growth rate over the past few years:
| Year | Total Distributions | YOY Dividend Growth Rate |
| 2017 | $2.96 | 10.04% |
| 2016 | $2.69 | 3.86% |
| 2015 | $2.59 | 7.92% |
As you can see, DVY has a history of boosting its dividend, and 2017 was one of its best years in that regard. Of course, history is only a guide, and should not be the only factor when forecasting how much dividends will grow this year. Fortunately, tax reform has freed up billions in overseas cash held by American companies, and the lowering of the corporate tax rate to 21% will likely improve free cash flow broadly across the economy. Expect to see dividend increases as an effect of this legislation. In fact, according to a survey done by Morgan Stanley last month, 43% of tax cut savings is expected to benefit investors in the form of stock buybacks and dividends. Great news for investors, especially dividend investors. Under this scenario it is not unrealistic to imagine DVY will boost its dividend by 15% this year, when using last year's 10% boost as a benchmark and factoring in tax reform benefits. If that occurs, DVY would yield over 3.5%, based on today's share price, which will help the fund buffer some of the effects of Fed rate increases.
Reduction in Utilities and Large Financials Exposure
Another reason I like DVY has to do with its sector weightings. While I am not very bullish on the utilities sector this year, it is a reliable sector known for having high dividend yields, due to predictable cash flows. Historically, this is a sector that will under-perform when interest rates are rising. This is because investors are able to get higher yields from other predictable sources, such as the U.S. government, diminishing the attractiveness of utility companies. However, DVY's inclusion of this sector is one of the principle reasons why its yield has stayed competitive, and bested many other dividend-focused funds, so this is not a sector I would abandon all together.
This is important because DVY has notoriously had a very large exposure to the utilities sector. Fortunately, given the pressure on the sector, DVY's stake has been reduced to over 25% its total holdings. While this is still its largest sector weighting and high in comparison to other dividend funds, it is down from over 29% in December. Therefore, I see this as a much more reasonable level of exposure, and I am less concerned about this sector dragging down the fund than I was last quarter.
Furthermore, DVY's second largest sector weighting, financials, is an area I am extremely bullish on this year, for multiple reasons. One, the financial industry will be one of the few sectors to actually benefit from rising interest rates, as their margins should increase, improving profitability. Two, the banking sector will benefit from a growing economy, which is currently what is happening. Three, there is potential to see meaningful legislation reform out of Washington D.C. with respect to rolling back some of the provisions in the Dodd-Frank Act. Currently, this initiative has some Democratic support, which will be crucial to getting any legislation passed. Among the items up for consideration are: raising the threshold for labeling banks as too big to fail (above the current level of $50 billion in assets) and reducing the reach of the Volcker Rule, which restricts banks from making market bets with their own capital. These items, among others, have been on Wall Street's wish-list for years, and seeing them materialize would undoubtedly benefit the financials sector, especially short-term. At over 15% of DVY's total holdings, this is important for the fund.
If we do see some regulatory changes, that will give further credence to my belief that dividends will go up broadly this year. Due to post-financial crisis reforms, banks and other lenders have held much more capital in reserves than they have historically, which has reduced their overall risk, and their returns. To illustrate this point:
US banks’ equity as a percentage of assets over the past decades:
Source: Fidelity
As you can see, capital has increased substantially. If the regulatory rollbacks include requiring less capital, banks would be able to deploy those assets more effectively, and one obvious use for that cash is to increase dividends.
Valuation Is Reasonable
A final reason for my preference for DVY has to do with the fund's valuation, which is very reasonable when compared to other high-yield dividend funds, as well as the broader market. This tells me DVY has reasonable downside protection, not only because of its high utilities' exposure but also because it has not been bid up as aggressively as other funds. To illustrate, I will list out the price to earnings ratios of some alternative funds: The Vanguard High Dividend Yield ETF (VYM), Schwab Strategic Trust (SCHD), iShares Core High Dividend ETF (HDV), and SPDR® Portfolio S&P 500® High Dividend ETF (SPYD).
| Fund | P/E Ratio |
| DVY | 19.18 |
| VYM | 21.30 |
| SCHD | 21.21 |
| HDV | 20.10 |
| SPYD | 16.20 |
While DVY is not the cheapest to be had, you can see it is more reasonable than other very popular funds. Throw in the fact that the S&P 500 has a current P/E above 25, and DVY looks reasonably priced indeed.
Bottom-line
DVY has struggled recently, and last quarter I had advised investors to trim their positions because of the rising interest rate outlook and the fund's over-reliance on the utilities sector. However, the recent correction has made me re-evaluate the fund, as its valuation and yield are suddenly more tempting. DVY has also boosted its dividend by double digits since my last review, and this is a trend I see continuing this year, as tax reform has improved the cash flow outlook at major U.S. companies. As volatility has come back in to the market, holding on to a defensive ETF with a growing dividend yield provides a nice hedge during any future correction, and I would once again recommend investors initiate positions in DVY at this time.
This article was written by
I began my career in financial services in 2008, at the height of the market crash. This experience has shaped my investment strategy - which is focused on diversification, dividends, and growth opportunities. I am a competitive tennis player, and I competed at the Division I level in undergrad. I have a Bachelors and MBA in Finance.
(He is a contributing author for the investing group CEF/ETF Income Laboratory where he specializes in macro analysis. Features of CEF/ETF Income Laboratory include: managed income portfolios (targeting safe and reliable ~8% yields) making use of high-yield opportunities in the CEF and ETF fund space. These are geared toward both active and passive investors of all experience levels. The vast majority of holdings are also monthly-payers, for faster compounding and steady income streams. Other features include 24/7 chat, and trade alerts. Learn more.)Analyst’s Disclosure: I am/we are long DVY, 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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