In previous articles I have explored several dividend and dividend-growth focused ETFs, SCHD and VIG. In the discussion that followed, a reader reminded me of the quality and consistent long-term performance of The actively managed Vanguard Dividend Growth Fund (MUTF:VDIGX). I was not unfamiliar with this fund, having owned it for a while seven years ago after reading about the excellent track record of its manager, Wellington Management’s Donald Kilbride in Dan Wiener’s newsletter, The Independent Adviser for Vanguard Investors.

VDIGX is the grandaddy of dividend growth funds, as it has been using a Dividend Growth strategy to identify quality companies since 2002–long before the Dividend Growth strategy went mainstream and before there were any ETFs in this space. It has often outperformed all the other dividend-focused funds and ETFs in terms of total return and it has also provided a better total return than the S&P 500 over long stretches of time. This is interesting because its expense ratio, .27% is significantly higher than that of the popular ETFs and S&P 500 index funds, which tend to be between .03-.08%. Price is calculated after deducting the expense ratio, so this suggests that the stocks in VDIGX are doing even better than the overall return of the fund would suggest. In the chart below you can see an example of a period when it performed very well compared to the Schwab US Dividend Equity ETF (SCHD), The Vanguard High Dividend Yield Index ETF (VYM), iShares Core Dividend Growth ETF (DGRO), and Vanguard’s other actively managed dividend fund, The Vanguard Equity Income fund (VEIPX).

Dividend Fund Comparison Chart

I included it as one of the dividend-growth funds I compared with the Vanguard 500 Index Fund in my previous article and was impressed enough with what I saw to want to do a deeper dive into its holdings to see if I could identify what was so special about the dividend growth stocks it holds. My interest was not academic. I was hoping that I could learn from Kilbride’s strategy to improve my own dividend-oriented stock picking skills. To begin my analysis, I downloaded the list of all the stocks the fund owns from the “Portfolio” link on Vanguard’s fund information page. Vanguard is to be commended for providing a list of every holding for each of its funds and ETFs, updated as of the end of the previous month. This listing was as of August 31, 2020. Vanguard also tells you the fund’s total net assets, which in the case of VDIGX are $43.9 billion dollars’ worth of stock, and the dollar amount of every stock it was holding as of the portfolio date. This allows you to compute the percentage each stock makes up of the fund as a whole.

I then looked up the tickers to each stock in the list (which Vanguard, unfortunately, does not provide) and made up a portfolio in FASTGraphs, which allowed me to see in tabular form a large selection of data which can be useful for evaluating an individual stock. This allowed me to quickly see each stock’s credit rating, current price, various future price targets, its current P/E, its average P/E over various stretches of time, its current dividend, its dividend growth history over various stretches of time, and the like. This data gave me some very good insights into what exactly is going on with VDIGX which I’ll now share with you.

VDIGX’s Has Far Fewer Holdings than the Competition

The first and perhaps most obvious thing that stands out about VDIGX is that unlike all its competitors, it holds a relatively small number of stocks, just 40. It keeps the number of its holdings at this level, buying and selling as the manager sees fit.

While investors might think that holding a fund or ETF with 200 or 400 stocks gives them more diversification, this is largely an illusion, because funds tend to be top heavy, dominated by the holdings stocks that have done very well. This means that no matter how many stocks these funds hold, when you buy a share of the fund, most of your money goes into buying the top 25 stocks in the fund. Most of the rest of the fund’s holdings make up only a fraction of a percent of the fund’s total assets. So by eliminating the extra hundred or so stocks you really don’t miss out on much. And since this is an actively managed fund, the relatively low number of stocks means that the manager can pay attention to each company in the fund, read its annual reports, pore over its balance sheet, and talk with management, something that no one does with the stocks that make up index funds or ETFs.

This is not to say that VDIGX isn’t somewhat top heavy, too. Its top 10 stocks make up 33.9% of all its assets. But because it holds fewer stocks all but two of rest of the 40 stocks in the fund make a meaningful contribution to its results, with the median holding being 2.25% of all assets and the average very close to this at 2.22. There are no stocks that make up .01% of the fund’s assets as is the case with the much larger index funds and ETFs.

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That the fund is a bit top heavy simply shows that while VDIGX lets its winners run, but it is pretty clear that it is managed so that every holding really counts, which is the way most individuals manage their portfolios.

VDIGX Is Not Investing for Short Term Dividend Yield

VDIGX’s dividend yield is wimpy compared to many other dividend-focused funds or many of the individual Dividend Growth stocks beloved by the Dividend Growth investors here on Seeking Alpha.

Morningstar reports that its yield over the trailing twelve months was 1.68% only 3 basis points higher than the 1.65% yield of the Vanguard 500 Index Fund (VFIAX) which tracks the S&P 500. Vanguard lists VDIGX’s forward-looking SEC yield as 1.75%. This is better than the 1.57% it lists as the SEC yield of VFIAX. But even so, 1.75% is not much yield from an investment that has seen its share price fluctuate from a high or $31.90 to a low of $21.38 in just the past year. You can still buy five year credit union CDs paying that much in many markets where you are taking no risk at all. VDIGX’s price could and probably will drop considerably during the next market correction and there is no guarantee it will bounce back quickly again.

If you are buying this fund, you are doing so as a buy-and-hold investor, hoping that the fund’s total return will continue to grow steadily upward over time as it has over the past 18 years and trusting that the stocks it holds history of dividend growth is pointing to them being stable, well run companies. And of course, trusting that Wellington Management and its manager Donald Kilbride will continue to pick excellent companies for their fund.

Dividend Yield and Dividend Growth are Not the Dominant Factor in Selection

Though Vanguard states “The fund focuses on high-quality companies that have both the ability and the commitment to grow their dividends over time.” A look at the individual holdings of this fund make it clear that VDIGX does not pick the companies it holds using any simple screens like “dividend yield over 2.5%” or “10 year dividend growth percent over 10%.” There are no “Chowder numbers” here. The fund seems to use much softer, complex criteria. In this it is very different from the index funds and ETFs and various quant funds.

The dividend yield of the stocks in the fund range from .35% to 4.37% with a median of 2.29%, and it is worth noting that the fund was still holding TJ Maxx (TJX) in August 2020, though it stopped its dividend this spring. I assume this is because a human brain decided that TJX will continue to raise its dividend when lockdowns end. (Which I agree with. I own it too.)

The 10 year dividend growth of VDIGX’s components range from a mere 4.20% to a whopping 151.80%, with a median of 11.40% So though the stocks in this fund do pay dividends and do have a history of dividend growth, it looks like having a history of dividend growth only qualifies them for selection into the fund. Other factors then become far more important in making the selection of the final 40.

Quality Appears to Be the Main Criterion

In my exploration of the holdings of other dividend funds and ETFs I found a large number of stocks with credit ratings in the lower tiers of the investment grade–those with ratings of BBB or lower. But that is not the case with VDIGX. Only two VDIGX’s 40 stocks have S&P credit ratings of BBB or BBB-and none are below investment grade.

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VDIGX Credit Rating of Holdings

The overall Return On Equity of VDIGX’s portfolio is impressive, too. This metric, which is believed to reflect how well a company’s management makes use of its resources is 26.6%, which significantly higher than the S&P 500s average of 20.1%. That these two measures are so much higher than what you see in other funds makes it very clear how seriously VDIGX’s management take selecting stocks for quality. Because this is a traditional managed fund, much of the evaluation of quality comes from the application of the human brain to the many factors that can’t be quickly uncovered with a machine algorithm. With so few stocks, the fund management can be very hands on immersing itself in companies’ financials, evaluating the quality of companies’ managers, and thinking deeply about what is going on in the markets for the companies’ goods and services. You won’t see any of this reflected in software screens, which is why you pay that higher expense ratio for active management.

VDIGX Offers True Sector Diversification

The chart below shows you how the stocks in VDIGX are distributed by industry.

VDIGX Industry of Components

Source: Industry information reported by FAST Graphs. Table by author.

Aerospace & Defense and IT Services are represented by three stocks, the rest only by one or two, allowing this fund with only 40 stocks to have a representative from each of 24 different kinds of industry. And with the quality emphasis, you can be sure these representative stocks have been chosen as best of breed.

BUT … The Valuation Of Its Holdings Is Very High

VDIGX faces the problem that all quality stocks and especially dividend growth quality stocks are facing now: severe overvaluation. As bond and CD rates declined towards 0%, investors desperate for yield have bid up the prices of high quality dividend payers to the point where it is very unlikely that there are any cheap, undiscovered gems left that the market has overlooked. There are stocks that look undervalued that stay have stayed undervalued among all the frenzy, but I am forced to conclude that these stocks (several of which I own, alas) are priced the way they are because people with a lot more money and connections than I have know something I don’t. So by definition, a fund full of high quality dividend growth stocks is going to be way overvalued right now.

The chart below shows how the P/E ratios of the stocks in VDIGX are distributed. As you can see, 12 have P/E ratios over 30. Another 16 have P/E ratios between 20 and 30. Only 12 have P/E ratios under 20, even though many of the companies in the fund are older, well established companies that are not growing at the kind of rate that would justify a growth stock type valuation.

VDIGX P/E Ratios of Holdings

Another measure of how out of whack these valuations are with stocks in the fund’s true prospects is the degree to which the current P/E ratio exceeds its average P/E ratio over the past five years. Fourteen of the stocks in this fund had P/E ratios at the end of August, 2020 that were over 25% higher than their average P/E over the past 5 years. Four had P/Es between 50% and 100% higher. Only five had P/E ratios more than 10% lower than their 5 year average.

VDIGX P/E Deviation from 5 yr P/E

Source: P/E and and 5 Yr Average Data reported by FAST Graphs. Calculation and chart by the author.

This is no reflection on Donald Kilbride’s stock picking. It’s just a reflection of how toxic it has become to invest in high quality dividend growth stocks.

After reviewing hundreds of individual stocks and combing through the better dividend-oriented funds, I am having to conclude that as much as we may be needing yield right now, it is looking downright dangerous to buy quality dividend paying stocks today.

The time will come when this is not true, and it may be sooner, not later. But wise investors will be patient over the next few months, waiting for better entry points even into quality investments like VDIGX.

VDIGX Has Some Peculiarities You Should Be Aware of Before You Invest

If you decide to put VDIGX on your shopping list, you should keep the following in mind.

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Backtesting VDIGX Can Be Misleading

VDIGX was a completely different fund before 2002. Back then it was the Vanguard Utility Income Fund which, as its name suggests, only held utilities. All sites that show you “maximum” charts for VDIGX show you its prices back when the ticker pointed to the utility fund. So if you must start any backtesting VDIGX, start only in 2002.

VDIGX Pays Out Sometimes Hefty Capital Gains at Year End

Because it is a managed fund that buys and sells stocks throughout the year VDIGX accumulates both long and short term capital gains which it distributes to investors in December. I mentioned that I used to own this fund. I sold it because I held it in a taxable account where I was hit with significant capital gains I had not expected. Because my state taxes short term gains at a high rate the tax on those gains decreased the value of the dividends I had received. This is not an issue in an IRA, so it is probably best to keep it in a tax-advantaged account.

VDIGX Distributes “Quarterly” Dividends Only Three Times a Year

For some reason, VDIGX distributes its quarterly dividends in March, June and December, skipping a September payout. Even if the dividend was higher, this might be discouraging to investors who rely on dividends to pay bills.

Vanguard Has A Nasty Habit of Changing Its Active Funds

Finally, I have been a Vanguard investor since 1988 and have learned the hard way that Vanguard is not committed to leaving its funds alone. Just as it changed my Utility Income Fund (VDIGX) into this version of VDIGX that is a Dividend Growth Fund, back at a time utility investing had lost its mojo, it is quite capable of changing this fund into something else again at some future time when Dividend Growth has lost its luster for investors. What it changes into may not be what you want to own. So you must stay alert.

Not only that, but Donald Kilbride, who has been hailed as the reason for this funds out-performance may not live forever, and even if he does, Wellington Management is quite capable of replacing him with another manager, just as Vanguard is quite capable of replacing Wellington Management with another management company or of adding additional management teams from some other company to Wellington’s team. They have done exactly that with several of their other actively managed funds over the past decade.

That means you have no guarantee if you invest in this fund for your retirement that it will remain the same fund over the next 20 or 30 years. This is not a big issue in a tax-sheltered retirement account but is a big headache if your fund is held in a taxable account and the fund racks up a large, taxable capital gain.

Vanguard’s management today is not what it once was when John Bogle was running the company and its focus on increasing AUM at any cost has come at the expense of its concern for the customer, which is making a lot of long-term Vanguard investors like me rethink our loyalty to the company.

CONCLUSION: VDIGX Has Been and May Yet Be A Fine Investment But Now Is Not The Time To Buy In

If you are investing in a tax-advantaged retirement account you could do a lot worse than to buy this fund–just not at the moment. Keep it on your watch list and invest when the yield rises and the price drops to where the holdings are better valued. Before you invest, double check that it hasn’t changed its management. Review its holdings before you buy in. The holdings I’ve analyzed here were those held on August 31, 2020. The fund buys and sells and may hold very different stocks in a few months.

As always when buying any fund, ask yourself if you would buy most of the stocks it holds today, and if you trust the management to stick to the formula that has served it so well since 2002. If the answer is yes, go for it!

Disclosure: I am/we are long TJX. 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.