Whether SCHD Is The Answer To Your Dividend Income Needs (NYSEARCA:SCHD)

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Why Consider SCHD?

With rates on bonds and CDs reaching low levels never seen in the long lives of today’s retirees, those needing income are turning to supposedly “safe” dividend stocks. This would incline many investors to choose a dividend ETF like Schwab’s U.S. Dividend Equity ETF (SCHD). Schwab’s website describes this ETF saying,

The fund’s goal is to track as closely as possible, before fees and expenses, the total return of the Dow Jones U.S. Dividend 100™ Index.

Tracks an index focused on the quality and sustainability of dividends. Invests in stocks selected for fundamental strength relative to their peers, based on financial ratios

This sounds attractive, especially to those who don’t have the time or inclination to do deep research into all the various dividend stocks available or who prefer to spread their risk by buying a basket of stocks rather than individual ones.

Those who have read my earlier articles know that I have long been a fan of CDs for income rather than stocks or bonds, but today, I count myself among those whose income needs are no longer being served by what even the best credit unions are offering.

Because I have come to appreciate simplicity in a portfolio as I get older, I took a look at SCHD before investigating individual dividend payers to see if it would serve my income needs. It lists a forward-looking SEC yield of 3.80%, as of Friday, August 27, 2020, and a backward-looking distribution yield of 3.36%, neither of which is shoddy. At first glance, it would seem like a no brainer to put the proceeds of my maturing CDs into this ETF and congratulate myself that I have diversified my dividend stock holdings in a way that should let me sleep well at night.

What is in SCHD?

But there is no magic to the ETF structure. You are buying a basket of stocks, and that basket is only as good as the individual stock holdings. So, before I invest in any fund or ETF, I take a look at its actual holdings and ask myself, “What am I actually buying.” Schwab makes it easy to see not only all the stocks SCHD holds but also what percentage of the ETF each stock makes up. You can download a spreadsheet containing this information at Schwab’s SCHD information page.

SCHD List of Holdings

SCHD is Very Top Heavy

The first thing that struck me looking at this list is how heavily weighted it is towards the top 12 stocks in the list. Summing up their percentages, we find they make up 49% of all holdings, even though they are only 12% of the 100 stocks held. This is not unusual in ETFs, and it can serve investors well if the top stocks in the ETF are those that are likely to continue to be market leaders. No one is complaining about Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) dominating the S&P 500. But this is not the S&P 500, so it is worth taking a very close look at those top 12 stocks, because 50 cents of every dollar you invest in SCHD will be buying those stocks.

Would I Buy the Top 12 Stocks in SCHD?

To evaluate these top 12 stocks more closely, I turned to a tool I have found very helpful when I was investing in individual stocks in the past: FastGraphs. I use it to help me quickly answer the questions that I ask about any stock I consider buying:

  • What is the company’s history of earnings, and how have they fared over the years?
  • How does the company’s current P/E ratio compare to its usual P/E ratio?
  • What industry is the company in, what is its credit rating, and what are the expectations for its future progress?

I’m investing in a taxable account, so I don’t have the luxury of selling an investment as soon as it starts looking a bit peaked. Short-term capital gains take a big bite out of short-term profits, especially as my state taxes them punitively. So, no matter what dividend a stock is paying, I only am interested in buying stocks I would want to hold at least for a year and ideally for a lot longer.

Ideally, the stocks I would want to buy would be those whose P/E ratio is not radically above its historical P/E. For a stock that is usually at a P/E of 17, that would mean I would want to keep the P/E under 20. I am aware that the long low interest rate period we have been in has pushed up P/Es across the board, but even so, these are mature companies well out of the aggressive growth phase that makes inflated P/Es acceptable.

Beyond that, I also want stocks only of companies whose businesses have been steadily growing their earnings throughout the last decade, ideally by growing their sales rather than using their capital for buybacks. It makes no sense to me to buy a stock for income and get, say, 4% a year from it, only to see its price drop by 15%.

I don’t expect big capital gains from these income-generating stocks, but I would like to see at least modest growth over a three or four-year period. My final criteria for any stock I buy nowadays is the creditworthiness of the company behind the stock. This can be measured partially by the company’s credit rating, which FastGraphs reports, but I have a human brain, too, and I like to use it, so I also think deeply about what business the company is in and how that business is likely to fare under the hitherto unimaginable scenarios we find ourselves in today when the COVID-19 pandemic has made it impossible for many of us to live normally without risking our lives.

Applying My Screens

Below, you can see how these stocks line up ranked by the percent their shares make up of the ETF’s holdings, their P/E ratio, how that ratio compares to their P/E ratio over the past 5 years (ending in 2019), their credit rating, and how their earnings per share have grown over the past five years.

Characteristics of SCHD Top 12 Holdings

Immediately, you see that, while most of these stocks have excellent credit ratings, the P/Es are another story. Seven of the 12 stocks have P/E ratios over 20, some well over, including Qualcomm (QCOM), Texas Instruments (TXN), BlackRock (BLK), and United Parcel Service (UPS) whose holdings make up the highest percentages of all holdings.

Most of their current P/Es are significantly elevated above their average, mostly inflated P/Es, too. This suggests that they are probably overvalued. If, like me, you believe that stocks that are not aggressive growth stocks are likely to see their P/E ratios revert to the mean, you might think twice about buying them at these prices.

In the case of 3M (NYSE:MMM) where the P/E ratio currently is below the historical 5-year average P/E, a look at FastGraphs’ historical graph suggests why this is. It depicts a company that has seen its price and earnings dropping over the past three years, after having been significantly overvalued.

Pfizer (PFE) is still dealing with losing its one cash cow, the blockbuster statin, Lipitor, when the patent expired, and Altria (MO), despite its profitability, has problems with large investors divesting from a company that sells a product that addicts young people and kills them in various unpleasant ways.

Looking at earnings, QCOM, TXN, UPS, BLK, Verizon (NYSE:VZ), and MO’s earnings per share growth rates are solidly above the S&P 500’s 5-year earnings per share growth rate of 6.61%, but the rest of these companies’ growth is modest to almost nonexistent, or in the case of IBM (NYSE:IBM), embarrassing. Would you really want to own a company whose last five years looked like this?

But the strength of a business involves its future prospects, and most of these are solid companies whose businesses are not going anywhere. So, so far, while I’m not excited about owning these companies at their current valuations, they aren’t as inflated as that of the S&P 500 with its current P/E of 24.68 (driven almost entirely by the FAANG stocks. You really would like to see the median P/E of the S&P 500 to get a better idea of how stocks are performing.)

What About the Other 51% of Stocks in This Index?

That is where things get very interesting, because, unlike the top 12, the credit ratings of the rest of SCHD’s holdings are ugly. Only 23 out of the 100 stocks have credit ratings of A- or greater, 12 are BBB+ rated, and the rest are BBB and lower, or else they aren’t rated. Why aren’t they rated? Because they are very small companies, eleven of them with market caps under $1 Billion, and many of them are regional banks.

That sends a huge red flag up, for me at least, because, in the current situation, where many millions of people are unemployed, with more layoffs being announced weekly, with 20% of renters not making timely rent payments, and whole industries shut down, regional banks are facing some very serious headwinds, which will appear in the form of mortgage defaults, car repossessions, and business loans that can’t be repaid.

Financials make up 24.48% of the holdings of SCHD. These are a mix of lots of those regional banks and quite a few insurance companies – which can’t profit on the money they hold when bond interest rates are almost zero. So, like it or not, when you buy this ETF, you are betting that the impact of the pandemic will be minimal in the year to come and that, like magic, everyone will be back at work, making back payments on their homes and cars and buying new ones at a rapid pace, while rates rise enough that banks and insurance companies can make some profits.

Would I Buy SCHD Today?

Nope. The combination of mostly overvalued or value trap stocks dominating half of the ETF and the rest far too vulnerable to the strange economic conditions we find ourselves in makes me take a pass. I am going to have to do the work involved in selecting individual dividend-paying stocks that meet my valuation criteria and pay enough of a dividend to be worth investing in. This isn’t easy, but I have found a few and will be checking each month to see if any more show up on my screens.

Your take on this might be different, of course. And it is worth remembering that this ETF has a turnover rate of 44.12%, according to Schwab, because the S&P index they follow will change periodically, casting out some stocks and buying new ones, which means that its holdings in another six months may be very different from what they are now. But, for now, these are not the stocks I would want to buy. How about you?

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.

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