Over the past few weeks, I have been carefully studying dividend-paying stocks and ETFs as I hunt for the best solution for providing income during a period when bonds and CDs no longer yield meaningful amounts of income. Having followed the writings of the dividend growth investors here on Seeking Alpha for many years, I investigated VIG and its associated mutual fund, VDADX, in my previous article, curious to see what the best-known Dividend Growth ETF could do for me, only to discover that its 1.66% SEC dividend yield was only 9 basis points higher than that of the S&P 500. This made me wonder how real the advantage was of buying more specialized dividend growth funds.
The S&P 500 Has an 11-Year History of Substantial Dividend Growth
To find out, I took a good look at the dividend growth history of the S&P 500 index, which can be easily visualized using the F.A.S.T. Graph of the index. Though the yield might be very similar to the dividend growth funds, that wouldn’t count for much if the S&P 500’s dividends have been erratic from year to year.
But as you can see in the F.A.S.T. Graph below, they weren’t.
The S&P 500 has had a steady history of impressive dividend growth starting in 2009, and current estimates are that this growth will continue, even though the total earnings of the stocks in the index are expected to decline at least for this year. I found this very interesting, because it means that the index as a whole meets the criteria used to pick stocks for Vanguard’s Dividend Appreciation Index Fund (VDADX). And that made me wonder if the investor buying a fund today that tracks the S&P 500 could capture the benefits of dividend growth investing, while also reaping any future benefits of growth and momentum stocks.
I Prefer the Mutual Fund Version of the S&P Index Instead of the ETF
I prefer mutual funds to ETFs, so if I were to invest in a security that follows the S&P 500, I would invest in the Vanguard 500 Index Fund (VFIAX). It was the very first index fund ever offered to the public, back in the 1970s, and continues to lead the pack. I have owned it on and off for years, exchanging it for the Vanguard Total Stock Market Index Fund (VTSAX) at times when I have had the ability to harvest tax losses.
I trust Vanguard with index funds, as the company has far more expertise in managing index funds than any of the competitors who have copied it. The company’s long history of offering funds with the lowest expense ratios makes it likely that it will continue to keep expense ratios down, while its competitors who are currently competing on price don’t have the histories that would convince me they might change course after I was invested in their funds.
There are several reasons why I prefer the mutual fund version of VFIAX to the ETF. One is that it is offered by many 401(k) plans that might not allow employees to invest in more specialized funds or to pick ETFs. I also think it is an advantage to the buy-and-hold investor not to have the value of the fund fluctuating through the day, which tempts them into buying and selling on impulse. But the main reason I prefer the mutual fund structure is that when you buy the fund, you are paying a price that reflects the actual value of the holdings of the fund. There is no premium or discount to the underlying value of the securities as there is with an ETF.
This can be an issue because there are times, especially during periods of market turmoil, when ETFs do not behave the way the stocks in their baskets of stocks perform. ETFs are dependent on a second layer of large institutional purchasers who buy and sell huge amounts of the ETF’s holdings to align the holdings with the value of the stocks in the index and hence provide liquidity. Old fogey that I am, I am not entirely convinced that this liquidity will continue. There has been a huge proliferation of ETFs over the past decade, requiring more and more activity on the part of those middlemen. We have seen liquidity dry up in bond markets, both long and very short, over the past year – even before the COVID-19-induced market crisis. So, it is not outside of the bounds of possibility that in a major crunch, with investors stampeding for the exits, the ETF market could also freeze up.
ETFs are supposedly more efficient, but I notice that despite Vanguard having a .01% higher expense ratio on VFIAX compared to its ETF version of this index, VFIAX consistently offers a slightly higher total return over the ETF. This has been true at the 10-year, 5-year, 1-year and 6-month intervals. For example, VFIAX’s total return over the last 5 years was 87.11%, while the ETF version’s return was 86.31%. Vanguard’s large-cap index funds do not distribute capital gains at year end, unlike its managed funds, so the tax efficiency is the same for the mutual fund and the ETF.
Comparing VFIAX’s Valuation with that of Vanguard’s Other Dividend Growth Funds
Next, I took a closer look at how VFIAX stacks up against the dedicated dividend growth funds as far as the valuations of the stocks that make up the fund. The table below shows you the value metrics of VFIAX and two other Vanguard Dividend Growth Funds taken from Vanguard’s portfolio page for each fund. They are current as of August 31, 2010.
One fund in this comparison is the previously mentioned Vanguard Dividend Appreciation Index fund. The other is the actively managed Vanguard Dividend Growth Fund (VDIGX), a highly selective fund which only holds 40 stocks, which has long been run by Donald Kilbride of Wellington Management and has a very impressive long-term history.
As you can see, all three funds have very similar P/E ratios and fairly similar yields, but the earnings growth rate of the stocks in VFIAX is much higher than that of the stocks in the dedicated dividend growth stock funds, which would help justify that higher P/E more than the earnings growth rate does of the other funds. The overall Price/Book ratio of the stocks in VFIAX is lower than that of the other two funds, which is a positive indicator. It is only when we look at the Return on Equity that the official dividend growth funds surpass VFIAX, with VDIGX doing by far the best.
Return on equity is a valuation measurement calculated by dividing net income by shareholders’ equity. It is thought to reflect how effectively management is using a company’s assets to create profits. So, in this regard, the dividend growth-focused funds may have an edge for the quality of management. Is that enough to justify the high P/E ratio with the slower earnings growth?
The Dedicated Funds Have Outperformed VFIAX Over the Longer Term. Buy You are Buying Today
Clearly, you would have done better to buy either VDADX or VDIGX five or ten years ago. But back-testing is often misleading, and in this particular case, I suspect it is very misleading. Why? because 5 and 10 years ago, dividend-paying stocks were nowhere near as overvalued as they have become in the intervening years, during which income-hungry retires have bid up their prices to levels very hard to justify using any value metrics.
As Chuck Carnevale has so often demonstrated here on Seeking Alpha, over the long term, stocks whose prices have become detached from the companies’ fundamentals usually see their stock prices stagnate or decline until they again reach a more reasonable valuation or become undervalued. This is particularly true of slow-growing stocks whose earnings increase only modestly – which describes a lot of popular dividend growth stocks.
The dividends paid by these funds were also considerably higher five years ago than they are today, largely as a function of the surge in dividend growth stock prices, which have risen much faster than companies’ dividend increases. So though the yield on cost of investors who bought these funds years ago is very good, the investor who goes to buy stocks or funds today will only get the yield the stock is currently paying and is buying a collection of stocks, many of which are seriously overvalued. As their composite yield is low, the advantage of dividend growth going forward is muted.
Even a hefty annual dividend boost, percentage-wise, is not going to turn into much more income with a sub-2% starting yield. 10% of $1.66 is $.17, and it would take several years of 10% annual dividend increases for the yield to even reach a very modest 2%. And at those sub-2% current yields, an investor buying in today would be earning only $17.50 for every $1,000 invested from even the highest-yielding of these funds.
Factor into this the inflated prices of the dividend-paying stocks and it is likely that a decline in price will undo any benefit from the dividend growth, and the size of the investment needed to generate significant income is such that the capital losses caused by P/Es reverting to the mean could also be significant.
What Sectors Dominate These Funds?
Given that we are entering what may be a recessionary period, and one that no matter what happens to the economy will see great changes in society due to the impact already wreaked by the virus on businesses and consumer behavior, it is worth looking at what kinds of stocks these funds are invested in. Below, you will find the sector breakdown for each fund, drawn from Seeking Alpha’s information page for that fund.
You can see that while all three funds hold a similar percentage of Financials and Consumer Cyclicals, which are the sectors most likely to suffer if rates remain low and unemployment is prolonged.
VFIAX, however, is dominated by in Technology stocks, which VDIGX holds very little of. These have been the best performers over the last year, and though many of them are also overvalued, as a group their growth rate is much better than that of more traditional sectors. This compensates for some of the apparent overvaluation.
VDIGX holds larger positions in Consumer Defensive and Industrials, with Industrials dominating that fund. It also holds a bigger percentage of Health Care than VFIAX. These are beaten-down sectors with more apparently undervalued stocks, but whether they are actually mispriced is something we will only know in a few years.
What are the Top 10 Stocks of Each Fund?
One thing that stands out to me about all three funds is how extremely concentrated their holdings are in their top 10 ten stocks rated by how much of the total value of the cash value of the fund they make up.
The top 10 holdings of VFIAX make up 30.2% of the entire fund on August 31, 2020, according to Vanguard’s fund page. The top 10 holdings of VDADX made up 35.6% of that total fund, and the top 10 holdings of VDIGX (which only holds 40 stocks) made up 33.9%. So, it behooves us to look at exactly what these top ten stocks are for each fund. The table below shows you Vanguard’s weightings of the top 10 of each fund as of August 31, 2020.
As you can see, VFIAX, as it is a broad market large-cap fund, holds a significant amount of growth stocks, though there is some overlap, with all three funds holding Proctor & Gamble (PG) and Johnson & Johnson (JNJ), and VDADX and VFIAX both holding Visa (V). VDIGX, as befits an active fund, does not cap-weight its holdings as the other funds do. This is an advantage and could explain some of its long-term outperformance.
The Dedicated Funds Will Dump Losers. Can VFIAX Still Keep Up?
The biggest obvious difference between VFIAX and these other funds is that VFIAX has no mandate to continue holding stocks that raise their dividends. The index governing VDADX is reconstituted once a year, so that it dumps any stocks that no longer are growing their dividends. VDIGX, because it is an active fund, can buy or sell any stock at any time, making it far more flexible and nimble. But VFIAX will continued to hold all the stocks in the S&P Index, which could have a negative effect on its dividend growth if a lot of companies are forced by economic conditions to cut their dividends. Though it is fair to point out that so far, there is no sign of this happening despite the current economic havoc, and analysts’ forecasts are that the S&P 500’s dividends will continue to rise over the next year.
Even in the worst case, though, the S&P 500 Index is also reconstituted from time to time and will drop companies that are not profitable. More to the point, individual stocks that decline in price will play a much small role in the overall results of VFIAX as others that rise in price will take their place. Stocks that cut dividends will be balanced by those that initiate or begin to raise dividends.
This ability to morph without having to buy or sell has long been the large-cap index fund’s strength. Winners come and go, but the current winners will always dominate VFIAX, both for growth and dividends, which is why its long-term performance has been good enough that Warren Buffett has specified in his will that his wife’s assets should be invested in VFIAX.
So, though we know that the dividends paid by VFIAX can decline during a major recession, as that is what happened during the Financial Crisis, even during the Financial Crisis, where financials did terribly and cut many a dividend, the overall decline was slight and recovered quickly. This bodes well for the future.
It’s also worth noting that all three of these funds’ prices responded almost identically during the correction this past March. The dividend growth emphasis did not protect the share prices or significantly speed the recovery, as you can clearly see on this graph generated using Seeking Alpha’s portfolio charting feature.
Conclusion: VFIAX Could Be A Legitimate Buy for Dividend Growth Fans
So, can VFIAX be considered a valid dividend growth investment? My take on this is yes, though I would not rush to buy it or any of these funds right now for income. I would, however, keep alert for an entry point where a price decline would boost the yield. If we have another correction, I would certainly invest in VFIAX.
But for now, the overvaluation of all three funds and the very small dividend yield would incline me to stay away and look to carefully chosen, decently valued individually chosen stocks for income in the short term. That said, I look forward to the day when I can buy VFIAX at a more reasonable valuation and enjoy its trend of consistent dividend growth, as I prefer not to have to deal with buying and selling individual stocks.
So, what do you think? Do share your take on this in the comment section!
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: I have owned both VFIAX and VDIGX at various times in the past. I only sold VFIAX to take advantage of a tax loss harvesting opportunity where I swapped the proceeds into VTSAX. I would buy both funds (VDIGX in a tax sheltered account) again if the valuations of their holdings improved.