SCHD Update Post-Reconstitution: Why I'm Now Bullish On This Dividend Growth Powerhouse

Summary

• SCHD reconstituted last month, resulting in some very favorable changes involving the Financials, Energy, and Health Care sectors.
• I'll look at SCHD at the industry level, showing investors why it is well set up to continue its strong dividend growth track record.
• I'll also highlight the top 20 holdings and some of the key indicators I believe are important for how they will perform as the economy continues to strengthen.
• I'm upgrading my rating on SCHD from neutral to bullish, as most of the changes made put it in a better position to capture the upside of undervalued, high-potential stocks.

Photo by oatawa/iStock via Getty Images

Investment Thesis

In late March, the Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD) reconstituted, resulting in some material changes that saw it decrease allocations to the Financials and Energy sectors in favor of Health Care and Information Technology stocks. This article will give an overview of the "new" SCHD ETF, one of the best-performing dividend ETFs available today. I'll also provide statistics at the industry and stock level, discuss its valuation and projected dividend growth rate, and weigh in on its constituents' high debt levels in light of Federal Reserve Chair Jerome Powell's recent "60 Minutes" interview. In January, I was neutral on SCHD, expressing concern about how investors would react to a slowing dividend growth rate, but the latest changes have alleviated these concerns. Therefore, I am upgrading my rating to bullish as the U.S. economy continues its strong recovery.

ETF Profile & Sector Changes

SCHD tracks the Dow Jones U.S. Dividend 100 Index, which is diversified across all industries (excluding REITs) and selects from U.S. companies that have made at least ten consecutive years' worth of dividend payments. Stocks must also have a minimum float-adjusted market capitalization of $500 million and an average three-month daily trading volume of at least $2 million.

The Index is ranked based on fundamentals, which gives weight to cash flow to total debt, return on equity, indicated dividend yield, and the five-year dividend growth rate. For a complete description of the Index construction and weighting methodology, please see pages 19-20 of this document.

Schwab charges annual fees of just 0.06% for SCHD, which has delivered incredible performance since its inception. Since November 2011, it has matched the S&P 500 (SPY) almost perfectly in both risk and return.

Source: Portfolio Visualizer

Why matching the market may not seem impressive initially, know that it has done so without much exposure to U.S. large-cap growth stocks, which have outperformed large-cap value stocks by nearly 5% per year during the same period. Also, the dividends earned have been much higher than the S&P 500. The table below shows the portfolio income generated on an investment of $10,000 in November 2011.

Source: Portfolio Visualizer

What Changed At Reconstitution Time

The reconstitution resulted in some very nice changes, many of which align with my market outlook for the next six months. It's about 6% less in both the Financials and Energy sectors, which have both had incredible run-ups lately and are likely due for healthy corrections in the near term. Offsetting this were additional stocks in the Information Technology and Health Care sectors. For those of you following my recent articles on Health Care ETFs, including XHE and IHI, I'm bullish on the Medical Equipment and Medical Devices industries, so these additions are very much welcome.

Source: Created By Author Using Data From SCHD ETF Overview

The top ten holdings have materially changed as well. Home Depot (HD) now occupies the top spot with a weight of 4.53%, while former top holdings such as Exxon Mobil (XOM) and Qualcomm (QCOM) were removed. Texas Instruments (TXN), International Business Machines (IBM), PepsiCo (PEP), and Coca-Cola (KO) remain a significant portion of the fund, though. Together, the top 10 and 20 holdings comprise 41.09% and 70.16% of the ETF, respectively.

Source: SCHD ETF Overview

Industry-Level Profile of SCHD

While I am pleased with the sector changes, this section will give an overview of SCHD's composition at the industry level. With the global pandemic changing the way sectors are viewed, I think it's necessary to go a little deeper to ensure the ETF can continue to deliver.

In total, SCHD invests in 38 different industries according to Yahoo Finance's classification system. The table below shows the weighted-average statistics of the top 15 industries, which make up 83.31% of SCHD. The last row shows the fund's statistics vs. the S&P 500.

Source: Created By Author Using Data From Seeking Alpha

First, note how the beta of 0.97 is almost in line with the market. I view this as a good sign, as it suggests SCHD is set up to track the market well but still produce an above-average yield. The 18.77 years of consecutive dividend growth is impressive and is backboned by dividend growth strength in the Specialty Industrial Machinery industry. This industry includes Emerson Electric (EMR) and 3M (MMM), both on dividend streaks longer than 60 years.

Despite having a beta close to the market, the fund's weighted-average forward P/E ratio of 18.70 is much cheaper than the S&P 500's, which I have calculated as 31.84 based on April 9 prices and cumulative weighted-average net income. I initially had an overvaluation concern given its 16.60% return so far this year, but this is still in line with the market. SCHD's constituents are trading 9.05% higher above their 100-day moving average prices, which is only slightly higher than the S&P 500's 8.83%. Finally, I would note that the market capitalization of SCHD is naturally much lower than the market due to its lack of mega-cap stocks like Apple (AAPL), Amazon (AMZN), and Google (GOOG). Even though 55% of SCHD's holdings are in the S&P 500, there is only an 11% overlap in weight, meaning SCHD investors are getting a much better diversified fund by cap size.

Source: ETF Research Center

Key Stats For Top 20 Holdings

As mentioned, the top 20 holdings account for 70.16% of the fund, so zeroing in on these stocks is essential to understanding the fund. Here are some selected key metrics I feel will be crucial to the fund's success:

Source: Created By Author Using Data From Seeking Alpha

Based on the above, I have the following observations:

• Revenue has grown at about the same pace in the last year as it has for the previous three years for SCHD's top 20 holdings (2.30% vs. 2.50%). I view this as a positive thing and representative of what makes SCHD attractive - selecting solid companies with good track records in all economic environments. Because of this, it has been able to maintain an excellent dividend growth record.
• My January opinion on whether SCHD could keep its dividend growth track record has improved. The three-year earnings from continuing operations growth rate is 10.95%, which is only slightly below these holdings' three-year dividend growth rate of 12.34%. If the economy continues to get stronger and there is no major wave of COVID-19 infections, I believe these growth rates will continue.
• The forward dividend yield of 3.16% is almost the same as the projected forward yield of the entire fund, so when you think of SCHD's dividend prospects, these 20 stocks are a good indication. A 3.16% yield on the April 9 closing price of $74.26 would mean an estimated annual dividend of $2.35, which is nearly 14% higher than 2020's annual payout of $2.05. This puts it just a bit higher than SCHD's five-year dividend growth rate of 12.20%.
• Debt may be problematic. The debt to free cash flow ratio of 3.28 is high, and according to my calculations, is about twice the weighted-average ratio for the S&P 500. Although most Federal Reserve members anticipate keeping rates near zero through 2023, the estimated inflation rate for this year was increased to 2.4% from 1.8%. News of members growing wary of moving up the rate increase timetable may hurt SCHD's constituents.
• On the other hand, in an interview on CBS News' "60 Minutes" released Sunday, Federal Reserve Chair Jerome Powell noted that the economic outlook has "brightened substantially," so there is good reason to believe these debt levels won't be problematic in the near term.

Investment Recommendation And Conclusion

My concerns in January about SCHD's potentially slowing dividend growth rate have been alleviated due to a much more robust and faster economic recovery than I had predicted. The gap between earnings and dividend growth rates has narrowed, and the recent optimistic comments from U.S. Federal Reserve Chair Jerome Powell added extra comfort. Also, I happen to favor lesser allocations to the Financials and Energy sectors, which have both been outperformers in the last several months. As I have written in several past articles on other ETFs, periods of high volatility among sectors often result in excessive profit-taking in outperforming sectors. SCHD's reconstitution resulted in a much higher allocation to the Health Care sector, which I believe is set to outperform the broader market.

Although SCHD has tracked the S&P 500 quite well since its inception, I believe it is more vulnerable due to its constituents' high debt levels. This may prove more problematic if rate hike fears increase, so I will be looking to the Fed for any signs of this. Still, the benefits likely far outweigh the risks, and I'm happy with most of the changes made, so I feel it's appropriate to upgrade my rating to bullish. With this, I would place it in the same category as the iShares Core Dividend Growth ETF (DGRO), which I recently wrote favorably on. It's low-cost, well-diversified, has the right sector mix, generates high income, and has a stellar track record, and I think it qualifies as a core holding in your dividend growth portfolio.

Analyst’s 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.