SDY: Certain Dividends In An Uncertain World

Summary

• SDY tracks an index of Dividend Aristocrats, which I view quite favorably in our current environment.
• The fund's top sector, Financials, is one of the cheapest in the market today. Further, it is a sector that often outperforms after market troughs.
• The fund's 3% yield looks attractive in a low rate environment, especially given its track record on dividend growth.

Main Thesis

The purpose of this article is to articulate why I believe the SPDR S&P Dividend ETF (NYSEARCA:SDY) is an attractive investment option at its current market price. With many headwinds on the horizon, I am looking for conservative plays for new capital right now. SDY fits the bill, as the fund holds Dividend Aristocrats, which are companies with a long-term track record of increasing their dividends. While SDY has dropped markedly off its high, I view current levels attractively. The fund's yield has been growing and sits over 3%. The Financials sector, SDY's largest by weighting, is cheap in relative terms and has a history of performing well after market sell-offs. Further, SDY is quite light on Energy exposure, which I view positively given my outlook for the sector is negative in the short term. Finally, the fund's valuation is noticeably below that of the broader market, which could mean less downside risk compared to the major indices.

Background

First, a little about SDY. The fund's objective is to "match the returns and characteristics of the S&P High Yield Dividend Aristocrats Index. This index screens for companies that have also followed a policy of consistently increasing dividends every year for at least 20 consecutive years". If a stock meets this criterion, it is included in the fund and SDY then weights the stock by yield. The fund currently sits at $85.49 and yields 3.16%. It has been a while since I reviewed SDY, and it was a fund I recommended about a year and a half ago. Since then, it has registered a positive return, but it has considerably lagged the broader market, as shown below:

(Source: Seeking Alpha)

Given all that has happened in the market since my last review, I wanted to take another look at the fund to see if I should change my outlook from here. While its underperformance is notable, I see current conditions as favorable to SDY in relative terms. Therefore, I believe a case to buy the fund can still be made, and I will explain why in detail below.

Dividend Growth and Valuation Are Positives

To begin, I want to look at two fundamental reasons why I like SDY at the moment. These are dividend growth and relative valuation, both of which I believe are especially important if one expects further volatility. As a fund tracking "Dividend Aristocrats", we should expect SDY to register dividend growth on an annual basis. Fortunately, this is the case. But what is particularly striking for me is the amount of growth, and how it registered in the most recent quarter. To illustrate, consider the chart below, which shows SDY's annual dividend growth for 2019, as well as for Q1 this year:

2018 Total Distributions	2019 Total Distributions	YOY % Gain
$2.44/share	$2.64/share	8%
Q1 2019 Distribution	Q1 2020 Distribution	YOY % Gain
$.53/share	$.67/share	26%

Click to enlarge

(Source: State Street)

As you can see, SDY has been delivering, in terms of dividend growth, during a difficult business climate. Further, its Q1 distribution was very impressive, well above what was paid last year. While I would expect the percent increase to be more modest the rest of the year, it does set the fund up nicely going forward.

The second point has to do with valuation, which is especially critical when the market is dropping, in my opinion. This is because if economic growth slows, or investors predict it will, the high-flying growth stocks with high earnings multiples are typically the hardest hit. Therefore, focusing on stocks or funds with reasonable valuations becomes increasingly important. This is another area where SDY intrigues me, as it trades at a much cheaper valuation than the broader market. To illustrate, consider the chart below, which shows the P/E ratio for SDY compared against the S&P 500:

SDY's Current P/E	S&P 500 Current P/E	SDY Discount to S&P 500
16.9	20.5	17.6%

Click to enlarge

(Source: State Street; Multpl.com)

My takeaway is both these metrics make SDY quite attractive to me right now. The fund is showing the underlying companies are still able to deliver on one of their core objectives, which is raising their dividends. Further, SDY sits at a large discount to the broader market, which may entice value investors who are concerned about another pullback in the major indices. All things considered, SDY looks like a reasonable play to limit downside risk from here.

Long-Term Performance Leads Broader Market

My next point looks at the underlying index that makes up SDY. This is the S&P High Yield Dividend Aristocrats Index, which is quite attractive for this "Dividend Seeker". While I enjoy dividends of all stripes, what I really look for is dividend safety, as well as growth. This index touches on both, as the companies within the index have proved they can withstand the test of time. Further, the index does not look simply at high yield, which can entice many investors. While on the surface these yields look attractive, then can be (and often are) cut when the market comes under pressure. We are seeing this play out today, as many companies in the heavily hit Energy and Real Estate sectors are indeed slashing their dividends. SDY, by contrast, has companies that are growing their dividends still, which is a very notable differentiator.

Of course, this all sounds good on the surface, but do investors really care? The answer, fortunately, is yes. While SDY is a fund I have long preferred individually, the market seems to agree as well. To illustrate, consider the long-term performance of the High Yield Dividend Aristocrats Index, compared against the S&P Composite 1500, as shown below:

(Source: S&P Global)

The performance over time by this index is clearly quite impressive. While SDY has only been around since November 2005, the fact that it tracks an index with such a strong record tells me this is a fund that could easily be a core holding in most investors' portfolios.

Financials Offer Attractive Risk-Reward Play

I now want to look at the underlying holdings for SDY to pointedly explain why I feel this fund could be a smart buy right now. Specifically, I am going to discuss the Financials sector, as this is the largest sector by weighting within the fund, as shown in the chart below:

(Source: State Street)

At just under 19% of total assets, the outlook for the Financials sector is clearly critical to SDY.

Fortunately, this is an area that I believe offers investors a strong value proposition at the moment. A key attribute for Financials is its relative valuation compared to the other sectors in the market. In fact, the sector has the cheapest relative valuation of all eleven sectors, and is actually trading below its historical average (represented by the blue box), as shown in the graphic below:

(Source: Fidelity)

As you can see, most sectors are trading very close to their historical average, with the exception of Energy, but the majority are slightly above their average. This contrasts with Financials, which is slightly below, setting up the sector to attract value-oriented buyers.

While the relative valuation is certainly a perk, what also interests me is the sector's historical performance following market sell-offs. While past performance in no way guarantees a similar outcome this time around, the strength of this sector after prior downturns is comforting. In fact, over the past fifty years, the Financials sector has the strongest return of all sectors following a market trough, as shown in the graph below:

(Source: Fidelity)

I view this quite positively, but must caution investors again that this is not a risk-free strategy. Buying in now makes two key assumptions. One, it assumes the sectors that have performed the best after prior market lows will register similar performance this time around. Given that this performance tends to be similar from recession to recession in the past leads me to believe it will happen again, but it very well might not. Further, it assumes we have hit our market trough, which could be a risky assumption to make considering the market has already rebounded sharply off its lows. If the market relapses or struggles to move higher, then this analysis will not prove very useful. But if the market continues to push higher, propelled by the re-opening of state economies and a flattening of the COVID-19 spread, then I would imagine the Financials sector will help drive funds like SDY higher going forward.

I Like What SDY Avoids - Energy

My final point touches on an area that SDY is underweight, which is the Energy sector. This may be surprising, given that SDY's top holding is Exxon Mobil Corporation (XOM) and Chevron Corporation (CVX) is the third-largest holding in the fund. However, these are the only two Energy names within the fund, which is why total exposure to this sector is under 5%, as noted in the chart in the prior paragraph. Simply, the general exclusion of this sector has worked to the fund's benefit over time, as Energy names have been pressured by rising production, falling energy prices, and a short-term decline in demand. In fact, when we consider the 5-year returns of the S&P 500, SDY, and the Energy Select Sector SPDR ETF (XLE), we see a sharp differential in performance:

(Source: CNBC)

Looking ahead, I see this as an area to avoid, and view SDY's light exposure to this sector as a positive. In fairness, I had recommended Energy exposure late in March, and the sector was a top performer through the month of April, returning over 30% to investors since my review was published (at the time of writing). However, a lot has changed since then, and I am more cautious on the sector now, leading me to believe taking profits here is wise.

For one, this short-term bump was very large, very fast, which usually makes me consider locking in some gains. Second, the price of oil has reached record-low territory and continues to be very volatile in the short term. In fact, the volatility got so extreme that crude oil even traded in negative territory last month, which is unprecedented:

(Source: Bloomberg)

The result of all this has not been positive on the sector. While the majors like XOM and CVX have been holding their own, many other companies are not faring as well. In fact, the falling price of oil has led to dividend cuts across the sector. A few notable mentions are Royal Dutch Shell (RDS.A, RDS.B) cutting its dividend by 66% in April, which was preceded by a similar announcement from Occidental Petroleum (OXY), which cut its dividend by 86% in March.

My takeaway from this is Energy will likely be a volatile space for some time, and dividend seekers may be wise to reduce their exposure to this area. With dividend cuts across the space, the inclusion of more Energy players into SDY's portfolio is not going to happen anytime soon. I view that as a positive for the fund as a whole.

Bottom line

SDY holds companies that are time-tested with respect to their dividends, and I feel this is a very important trait right now. With so much uncertainty in the world, finding an income stream that is reliable is a laudable goal, and this fund delivers it. With a growing dividend above 3%, a strong track record of performance, and exposure to the right types of sectors in this environment, I view SDY as a clear Buy. Therefore, I am adding to my position in the fund, and I would recommend investors give SDY some consideration at this time.

Analyst’s Disclosure: I am/we are long SDY. 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.