(08/28/15) Ben Graham and Dividend ETFs

Ben Graham is often described as the father of value investing. He might also be described as the father of strategic beta, suggests Michael Rawson in Morningstar ETFInvestor.

In his classic book, The Intelligent Investor, he laid out a number of quantitative rules with which to evaluate stocks.

These same concepts underlie the indexes that form the basis of many of the dividend oriented ETFs investors use today. The rules are:

1) There should be adequate, though not excessive, diversification.

2) Each company selected should be large, prominent, and conservatively financed.

3) Each company should have a long record of continuous dividend payments.

4) The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years.

I searched the Morningstar database for dividend-oriented funds. I eliminated international and sector funds from the results.

This resulted in a list of 17 ETFs with over $1 billion in assets that use dividends as part of their screening methodology.

Dividend oriented ETFs can generally be split into two camps: those that seek out stocks with high dividend-yields and those that seek out stocks with growing dividends. I’ve grouped funds along these broad lines.

Funds that seek out stocks with the highest yields may not be appropriate as core portfolio building blocks, but they could be employed as a tactical tool to improve the yield of the overall portfolio.

Good examples include iShares Select Dividend (DVY), which weights stocks that survive several screens by per-share dividends.

ALPS Sector Dividend Dogs (SDOG) buys the five highest-yielding stocks from each of ten sectors. WisdomTree Equity Income (DHS) starts with the highest yielding 30% of the market by dollar amount of dividends paid.

PowerShares S&P 500 High Dividend ETF (SPHD) takes the 75 highest yielding stocks in the S&P 500, selects the 50 with the lowest volatility, and then weights them by yield.

Some yield seeking funds rely on diversification to dull the sting of catching falling knives.

Vanguard High Dividend-Yield ETF (VYM) weights the highest yielding stocks by market cap and keeps including stocks until it reaches 50% of the market value of the dividend paying universe.

WisdomTree Total Dividend ETF (DTD) contains virtually all dividend paying stocks and weights them by the dollar amount of dividends they pay.

PowerShares FTSE RAFI US 1000 ETF (PRF) weights stocks based on the five-year average of dividends, sales, cash flow, and the most recent book value.

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Some funds tilt toward mid-cap companies, where higher yields can be found.

WidsomTree MidCap Dividend (DON) weights mid-cap stocks by the dollar amount of dividends paid. Global X SuperDividend US ETF (DIV) equally weights 50 high-yielding stocks and includes master limited partnerships and REITs.

The field of dividend growers tends to have little, if any, overlap with the field of high yielding stocks. These companies aren’t likely to offer the highest yields; the hope is that their dividends will grow in the future.

The indexes designed to isolate these firms typically use several screens based on financial statement data, such as dividend payout ratio or debt/capital to winnow down the field.

For example, Schwab US Dividend Equity (SCHD) ranks stocks that have paid dividends over the past ten years by yield, scores those in the top half on various measures of financial strength and finally weights the top 100 by market cap.

iShares MSCI USA Quality Factor (QUAL) scores stocks based on return on equity, debt, and earnings stability and weights them by their quality score-adjusted market cap.

Vanguard Dividend Appreciation ETF (VIG) looks for stocks that have increased dividends for ten consecutive years that also pass some additional, undisclosed screens.

WisdomTree US Dividend Growth (DGRW) dividend weights 300 companies with high return on equity, return on assets, and forecast earnings growth.

Each of these ETFs has a large percentage of its assets in stocks that have a wide Morningstar Economic Moat Rating, showing a competitive economic advantage.

Companies that have a long track record of paying dividends and are able to consistently pay dividends throughout market cycles typically have stable, repeatable business models or strong brands that give them pricing power.

SPDR S&P Dividend ETF (SDY) looks for companies that have increased dividends for 20 consecutive years and weights them by yield.

PowerShares Dividend Achievers (PFM) market-cap weights stocks that have increased dividends for at least ten years.

PowerShares High Yield Dividend Achievers (PEY) takes the 50 highest yielding stocks from the dividend achievers list.

The average dividend-yield for the 17 stocks discussed above, gross of the fund expense ratio, is 4.1% for the high dividend-yield group, versus 2.8% for the dividend growers.

In contrast, dividend growers have a historical earnings yield of 4.9% and estimated earnings growth of 8.8%.

This is higher than the 1.4% historical growth and 7.6% forecast growth for the ETFs in the high dividend-yield group.