At the end of march 2023, the Schwab U.S dividend Equity ETF (NYSEARCA: SCHD), went under a so-called annual reconstitution – in a few words, a process in which some stocks of the ETF get removed and some new ones get included.
Although in the investing community there has been a concern that the changes in SCHD didn’t actually account for the recent banking crisis, which is partially true, I do believe that we are still in a great moment to buy this ETF. As a matter of fact, this is probably the perfect moment.
We’re going to discuss the good and the bad of the annual reconstitution of SCHD and we’ll take a closer look at the current valuation and what happened in the past few months.
Why less is better
Before getting into the main part of the post, I want to address one important thing first. As an investor, your goal should always be to attain the best results in the long term, and in my experience, finance and investing are one of the things that are best kept simple. If you spend countless hours analyzing hundreds of ETFs and investing in many of them, eventually you’re not going to have a better return in the long term. In fact, most likely you’re going to ruin it.
There are literally hundreds of different ETFs that constantly try to beat the market and constantly fail to beat it in the long term.
Really, you can get lost on them.
Some of them try through call option strategies, like SVOL or JEPI, which perform well only in bear markets. Some give you incredibly high dividend yields, which in the end are just a dividend trap. Some are actively managed, and eat out most of your earnings over time.
You can gamble as much as you want, but if you want to achieve the best results in the long term, there is no better way than keeping your portfolio simple and invest in broadly diversified ETFs like SCHD if you like dividends, or the S&P500 for a broader diversification.
How much will you make with SCHD
SCHD grew with an average of 12.09% in the last 10 years and this even considering that since May 2021 the ETF flattened like the S&P500 because of the crisis.
I took the time to create a table that shows you how much you need to save and invest every month if you want to become a millionaire by the age of retirement if you invested in SCHD with an average return of 12%. Of course past performances are not a guarantee of future results, but I’m not expecting SCHD to perform under an average of 9-10% in the long term future.
What you can notice right away is that you actually don’t need so much savings in order to retire as a millionaire. And the younger you are the easier it’s going to be.
For example if you are between 20 and 24 years old right now you are going to need to invest between $37 and $59 per month until the age of retirement. If you start investing later in life the amount grows but, except by starting after your 50s, it’s still going to be pretty easy.
This incredible growth comes from the compounding of the returns that you get when you hold an investment over a long period of time. It’s the greatest asset of an investor and it’s the reason why choosing a broad ETF which covers a good part of the market and manages to keep a constant return around 10% is way better than trying to find ETFs or stocks that make 20% returns, because, most likely, in the long term you’re going to achieve much less returns.
Let’s move on now to the reasons why I believe we are in a good moment for buying SCHD. At the end of march 2023, SCHD completed its annual reconstitution, which as I said, is a process in which the stocks included in the ETF get rebalanced.
This year a total of 25 companies were added and 24 were removed. The biggest deletion was IBM, which was completely kicked out.
Before thinking this is a bad thing, let’s see how SCHD chooses its stocks.
SCHD tracks the Dow Jones U.S Dividend 100 Index, selecting 100 U.S. securities, excluding REITs. The index is built entirely by an algorithm, without any human decision. So, how does this algorithm decide which stocks to pick? First of all, all the stocks are screened using these 3 criteria. They need to have:
- minimum ten consecutive years of dividend payments
- minimum $500 million float-adjusted market capitalization
- minimum $2M of three-month average daily trading volume
All the stocks that match these requirements are then ranked by dividend yield. This is the reason why mega-cap tech companies like Apple (AAPL) and Microsoft (MSFT) never qualify for this ETF.
Now, the final decision of which stocks will be finally selected happens based on 4 factors:
- the average dividend growth over the past five years
- The free cash flow to total debt
- The return on equity
- The expected forward yield.
The following chart shows the % sector weight in SCHD’s portfolio before and after its Reconstitution, and it’s very clear that the exposure to the financial and tech sectors has been reduced substantially.
Information Technology dropped from 22.53% to 16.78% and financials from 18.90% to 13.9%. On the other hand, Healthcare had the highest increase going from 11.15% to 16.52% and Energy followed going from 5.17% to 8.96%.
It’s important to notice that the drop in Information Technology was caused mostly by the sector price drop and not really because tech companies have been eliminated.
IBM is a technology company that produces and sells hardware and software, Cummins is an Engine manufacturer and Prudential Financial is a Global Financial Service company that provides insurance. In 2019, Prudential Financial was the largest insurance provider in the US with 1.35 trillion dollars of total assets under management.
The reason why these companies were dropped lies in their fundamentals. IBM’s free cash flow per share fell from $11.19 to $9.38 while Cummins dropped from 10.53 to 7.39. Essentially, this means that these companies have less capacity to increase dividends at a high rate, which is SCHD’s key investment objective.
The following is a list of the companies that were deleted from SCHD’s portfolio. You can notice that quite a few of them are financial stocks. However it is important to note that, excluding the top three, the remaining 21 Securities had a combined waiting of 5.92%.
The index also added 25 Securities and the following chart shows all of them sorted in order of market cap with total returns of each stock in 2022.
The key additions were AbbVie (NYSE: ABBV), a biopharmaceutical company, Chevron Corporation (NYSE: CVX), an oil and gas company, and United Parcel Service (NYSE: UPS), a logistics company. Looking at the total returns from the chart, AbbVie gained 24.04% and Chevron 58.48% last year. Moreover, the two companies boosted their quarterly dividend yields by 4.96% and 6.34%, respectively.
The good thing is that these dividend yields are pretty high, but also sustainable. AbbVie’s free cash flow per share in 2022 was $13.69 compared to $12.49 of 2021, with an increase of 10.23%. Chevron, instead, increased its free cash flow per share from $11.03 to $19.49, which is an incredible 76.70% jump.
In case you don’t know, the free cash flow per share indicates how much cash the company generated relative to the number of shares outstanding and it’s used to evaluate the company’s ability to generate cash.
Back-tested Results: Current Portfolio
The following chart shows the results of the SCHD’s new 2023 portfolio back tested from 2017 compared to the previous portfolio composition of the same ETF and to the S&P500 through the SPY ETF.
As you can see, the new portfolio would have outperformed the previous SCHD and SPY by an annualized 1.25% and 1.48%, with a better overall performance from 2021 to 2023.
An investment of ten thousand dollars in SCHD’s 2023 portfolio would yield $21,335, outperforming the old version and the S&P500 by almost $2,000. This signals that, although many of of the new additions to SCHD’s holdings have suffered significant price drops, the success key are the fundamentals that the index uses to evaluate companies that it decides to invest in. This is why the profitability rating of this ETF is extremely high and after the reconstitution went from 9.34 to 9.53/10.
Now, this other chart shows the annual returns of SCHD’s 2023 portfolio compared to the previous portfolio and to SPY:
This chart is more relevant to investors focused on dividend income because it shows the annual portfolio income of an initial 10 000 investment if all dividends were reinvested. As you can see, the portfolio income of the new SCHD would have grown from $324 in 2017 to $769 in 2022: that is an almost 19% five-year growth rate which beats the ETF’s growth rate of 17.44%.
Now what do we know about the future of this ETF? Well, past performance is never an indication of future performance but considering the back testing it’s done pretty well so far and the additions make it a solid ETF that will keep solid dividend yields in the future.
Right now SCHD is providing a 3.77% dividend yield which is amazing, has a five-year beta of 0.89, which being under 1 means that the ETF has low volatility, and has an estimated 5.32% earnings growth rate.
Second reason, the loss of Tech
The second reason why I believe this might be a good moment to buy in this ETF is the poor performance of the last months and the reason behind it.
This year SCHD has significantly underperformed the S&P 500 as you can see from the following graph, and this happened primarily due to its previous exposure to the tech and financial sector.
You probably know about the collapse of the Silicon Valley Bank on March 8 2023 and of the Signature Bank later in the same month. These recents failures of the banking system have impacted the whole financial sector and, to a lesser extent, even the technology sector.
The financial and Technology sectors made up 18.9% and 22.5% of SCHD’s portfolio at the end of December 2022, making SCHD underperform the S&P500. But it’s also true that even though in the short term this is not a positive period for the banking system, in the long term the strong drop in prices in the financial sector puts us in a more favorable position to buy into this sector.
Beside this, the exposure to financials is much lower now. So the ETF reconstitution of march 2023 actually put us in a better position to buy in this moment.
Same goes for the technology sector. If you only think short term, you might be afraid of what’s possibly going to happen in the next months, but for the long term you need to consider that the sector has been going down since beginning of 2022 and we are now in a phase of recovery that will likely put us in a good earning position in the next years.
There are some potential downsides to the changes of SCHD and they are related to the key additions Abbvie, Chevron and UPS.
Starting with UPS, according to various sources like Seekingalpha.com, SCHD has now a lower earnings momentum because of the poor recent earning results from UPS and Texas Instruments. So adding UPS could slow down its dividend growth rate in the future and might not be the best outcome for dividend investors.
The second downside comes from Chevron. The oil and gas sector boomed in the last years because of the global energy crisis, but it’s not sustainable in the long term. Chevron in particular had a total growth of 58% only in 2022 making it a potentially overvalued company:
Still, oil and gas only covers 3.9% of the total SCHD portfolio and I expect Chevron to be able to pay extremely good dividends in the future because the high energy prices are not coming back to the values of 2020 anytime soon.
The last downside is related to Abbvie. Their main product is a drug to treat autoimmune diseases called Humira, that in 2022 accounted for 37% of the total revenue.
The threat here comes from a cheaper copycat of Humira that has been developed and released in February 2023 by Amgen (NASDAQ: AMGN), another big pharmaceutical company. Because of this, Abbvie expects a 37% drop in Humira sales this year.
While this might look like a really dangerous threat, the positive side is that in SCHD, Amgen has basically the same weight as Abbvie. So whatever drop in price is going to affect Abbvie in the short term because of the competition with Amgen is going to positively reflect on Amgen, balancing the portfolio and minimizing the volatility.
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