Don’t Write Off High-Dividend Stocks Yet

by Daniel Putnam | April 3, 2012 11:48 am

Don’t Write Off High-Dividend Stocks Yet

High-dividend ETFs just suffered their worst quarter of relative performance relative to the broader market since the first quarter of 2009. While the SPDR S&P 500 ETF (NYSE:SPY[1]) rose 12.69% in the first three months of the year, the Vanguard Dividend Appreciation ETF (NYSE:VIG[2]) gained 7.65% and the iShares Dow Jones Select Dividend Index Fund (NYSE:DVY[3]) returned just 4.77%.

Does this make the dividend ETFs likely candidates for mean reversion in the quarter ahead, and if so, which of the two is the better bet?

DVY vs. VIG

The two ETFs are close in terms of assets ($10.9 and $10.1 billion for VIG and DVY, respectively), but they are very different in terms of their holdings. While DVY[4] puts a greater emphasis on stocks’ absolute yield levels, VIG[5] is tilted toward those with the potential for dividend growth over time.

DVY, therefore, holds a slightly more eclectic portfolio, and it has a much heavier weighting in the defensive market segments, with 53.3% of its assets in the utilities, telecommunications, consumer defensive and health care sectors. VIG, on the other hand, holds only 33.6% in these areas.

Sector VIG DVY Difference
Consumer Defensive 26.75% 16.14% -10.61
Industrials 23.32% 15.17% -8.15
Energy 15.58% 3.59% -11.99
Consumer Cyclical 11.49% 7.11% -4.38
Financial Services 6.11% 10.36% +4.25
Health Care 5.53% 3.72% -1.81
Technology 5.37% 4% -1.37
Basic Materials 4.47% 6.3% +1.83
Utilities 1.23% 30.31% +29.08
Communication Services 0.12% 3.19% +3.07
Real Estate 0% 0% 0
Source: Etfdb.com

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The result of these differences is twofold. First, VIG has a lower yield: 2.1% — not much higher than the 1.9% for SPY — compared with 3.5% for DVY. Second, it tends to track the performance of the broader market more closely. In this case, that has proven to be a good thing. Since VIG’s inception on April 21, 2006, it has generated a total return of 30.84% — well ahead of both DVY (+6.51%) and SPY (+20.82%).

Note: These returns don’t correspond to the numbers in the above chart since dividends aren’t incorporated, but the charts still provide an accurate visual representation of the performance gap.

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Much of DVY’s longer-term underperformance stems from its tilt toward financial stocks heading into the crisis. If you take this out of the equation and look only at the period from March 2009 to the present — also a time in which stocks with high absolute yields have been in vogue — DVY has in fact come out on top.

All factors considered, DVY beats VIG as a proxy for the dividend-stock universe. Its higher yield, lower correlation to the broader market and portfolio structure all indicate that it is a better option than VIG for an investor who wants to isolate the performance of high-dividend equities.

Assessing the Odds of Mean Reversion

The next question is whether DVY is set to close its first-quarter performance shortfall in the month ahead. First, a look at some historical factors:

Given the inconclusive nature of the historical data, investors might be better served by looking at the sector breakdown of DVY versus SPY to see if a second-quarter mean reversion is in order.

Sector SPY DVY Difference
Technology 18.61% 4% -14.61
Financial Services 13.07% 10.36% -2.71
Energy 11.94% 3.59% -8.35
Industrials 11.69% 15.17% +3.48
Consumer Defensive 11.37% 16.14% +4.77
Health Care 11.13% 3.72% -7.41
Consumer Cyclical 9.46% 7.11% -2.35
Communication Services 4.13% 3.19% -0.94
Utilities 3.34% 30.31% +26.97
Basic Materials 3.24% 6.3% +3.06
Real Estate 1.78% 0% -1.78

From this table, it’s apparent that the two largest sector divergences are technology and utilities. Not coincidentally, technology was the second-best sector behind financials during the first quarter, while utility stocks lagged the market by a wide margin. This, more than anything, helps explain the underperformance of DVY in the first three months of the year. For DVY to play catch-up in the second quarter, we will likely need to see a pause in the tech rally and/or a rebound in utilities.

Factors that would facilitate a reversion trade in utilities would be a rebound in natural gas prices and stable to lower interest rates, while the key factor fueling a pullback in tech would — of course — be a slowdown in Apple (NASDAQ:AAPL[6]).

The Prediction

With all of the hype surrounding dividend stocks in the second half of last year, a period of underperformance had become almost inevitable. Now, a further shortfall in DVY will require the continuation of several trends that are already very extended: the rally in Apple, the drop in natural gas and the continued positive news flow needed to keep the VIX in the mid-teens. If one or more of these reverses in the quarter ahead, DVY likely will close its performance gap relative to the rest of the market.

In short, don’t write off high-dividend stocks just yet.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Endnotes:
  1. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  2. VIG: http://studio-5.financialcontent.com/investplace/quote?Symbol=VIG
  3. DVY: http://studio-5.financialcontent.com/investplace/quote?Symbol=DVY
  4. DVY: http://us.ishares.com/product_info/fund/holdings/DVY.htm
  5. VIG: https://personal.vanguard.com/us/FundsAllHoldings?FundId=0920&FundIntExt=INT&tableName=Equity&tableIndex=0&sort=marketValue&sortOrder=desc
  6. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL

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