CDC: Three Layers Of Portfolio Protection (NASDAQ:CDC)

Investment Thesis

If the phrase “conservative dividend investor” describes you, there’s a good chance you’ll find the Victory Portfolios EQ Income Enhanced Volatility Weighted ETF (CDC) appealing. CDC offers three layers of portfolio protection in the form of high dividends, low volatility levels, and a policy of exiting equities in favor of U.S. treasuries during early signs of market turmoil. And, unlike other low volatility ETFs that substantially underperform during rising markets, CDC holds its own against its more risky competitors. CDC has better risk-adjusted returns than the S&P 500, and its constituents have double-digit EPS growth estimates and an ultra-low 15.80x forward P/E ratio. For these reasons, I’m maintaining my buy rating on CDC today, and I look forward to taking you through this unique ETF in more detail.

ETF Overview

Strategy and Fund Basics

CDC passively tracks the Nasdaq Victory U.S. Large Cap High Dividend 100 Long/Cash Volatility Weighted Index. This Index selects the largest 500 U.S. equities, except for REITs, and eliminates those without four consecutive profitable quarters. The highest-yielding 100 stocks are selected and inversely weighted by their 180-day standard deviations of price returns. In addition, sector exposures are capped at 25%, and the Index is reconstituted semi-annually in March and September. The weighting scheme should result in a near-equal-weight Index because unlike market capitalizations, the range of standard deviations among large-cap stocks is usually small.

While dividends and low volatility offer two layers of protection, it’s the last layer that makes CDC unique and most appropriate for conservative investors. Following a rules-based methodology, CDC will exit equity positions in favor of treasury bills whenever its Index price hits certain trigger points relative to its All-Time Highest Daily Closing Value (“AHDCV”). These trigger points are summarized in the second column of the table below (NQVWLD).

Importantly, no additional exits are allowed until the Index has returned to being fully invested in equities. For example, if the Index falls 24%, triggers a switch to 25% treasuries, and then gains back 8%, the Index will not move to 50% treasuries in line with what the table suggests. Once an exit is triggered, the Index will only move in one direction toward being fully invested again. Admittedly, the methodology document is murky on the exact path toward reinvestment, but we can draw some conclusions by comparing the returns of the Reference Index with CDC’s actual returns during such volatile periods.

December 31, 2018

The Reference Index closed at 1,751.34, or 12.11% below its all-time high price of 1,992.64. Subsequently in January 2019, the Index gained 7.54%, but CDC gained 2.15%. This 5.39% underperformance is consistent with a move to 75% treasuries. In February 2019, the Index gained 2.93% while CDC gained 3.13%, suggesting CDC was back to being fully invested that month.

February 28, 2020

The Reference Index closed at 1,836.96, or 14.85% below its all-time high price of 2,157.37. Subsequently in March 2020, the Index lost 19.21% but CDC lost just 1.04%. This 18.17% outperformance is also consistent with an aggressive move to treasuries, which performed well at the time. However, the Index gained 10.42% in April 2020 while CDC gained 11.04%, so it seems like CDC was back to being fully invested again that month.

While drawdowns were infrequent since the fund’s inception, this small sample shows how well this strategy can pay off. It won’t get it right every time, but its primary purpose is to protect capital. I will show later why I think it can do more than that in rising markets too, but first, here are some additional statistics for easy reference.

• Current Price: $70.01
• Assets Under Management: $1.21 billion
• Shares Outstanding: 17.9 million
• Expense Ratio: 0.36%
• Launch Date: July 1, 2014
• Trailing Dividend Yield: 2.62%
• Three-Year Dividend CAGR: 8.24%
• Five-Year Dividend CAGR: 9.22%
• Five-Year Beta: 0.54 (0.85 for current portfolio assuming no exits)
• Number of Securities: 103
• Assets in Top Ten: 14.66%

Sector Exposures and Top Holdings

At the moment, CDC is 100% invested in equities, with exposures mostly in defensive sectors like Utilities, Financials, and Consumer Staples. These three total 63.64%, while other sectors like Consumer Discretionary and Industrials have less than 5% exposure each.

Since CDC weights constituents based on volatility, it nearly ends up being an equal-weight ETF. The top ten holdings confirm this, and currently include high-quality names like PepsiCo (PEP), Coca-Cola (KO), and Costco (COST). The latter is an interesting one, since I warned of its high valuation when reviewing the Vanguard Consumer Staples ETF (VDC) on January 4. There are a few high P/E stocks peppered throughout CDC, but they are few and far between, and I think you’ll find CDC plays in the same league as large-cap dividend ETFs these days.

Historical Performance

By far, the two largest low-volatility-themed U.S. Equity ETFs are the iShares MSCI Minimum Volatility USA ETF (USMV) and the Invesco S&P 500 Low Volatility ETF (SPLV). I prefer USMV at the moment, so I will be comparing CDC’s fundamentals to it in the analysis section later. However, the graph below highlights CDC’s historical performance against USMV, SPLV, and the SPDR S&P 500 Index ETF (SPY) since its inception.

As shown, CDC outperformed USMV and SPLV by 1.34% and 2.45% per year with a similar level of volatility. The lower maximum drawdown in Q1 2020 was a key performance driver that resulted in better risk-adjusted returns (Sharpe Ratio) even when compared to SPY. In my view, this performance history makes for a strong case that CDC isn’t just good for managing downside risk; it turns out it can perform well in rising markets too, which is the point I’ll look to make next.

CDC Analysis

The following table highlights selected metrics for CDC’s top 20 industries, as well as summary metrics for both CDC and USMV. In the case of equal-weight ETFs or those with low concentration levels, I find industry-level analysis to be a nice compromise between analyzing only the top ten holdings and making broad assumptions about how sectors may perform going forward. Plus, this type of analysis makes it easy to see which industries contribute most to the safety, income, and growth portions of the portfolio.

While CDC certainly is the more volatile of the two, as suggested by its constituents’ five-year beta of 0.85, I don’t have an issue with it because of the strategy of switching to treasuries once the market begins to slide. CDC’s constituents also have a much higher forward dividend yield (3.40% vs. 2.09%), and this is a stand out among all 28 U.S. low-volatility ETFs I track in my database. While the net yield will end up closer to 3.00% after fees, there aren’t many others that combine high yield with low volatility. Alternatives in this category would be the Invesco S&P 500 High Dividend Low Volatility ETF (SPHD) and the Legg Mason Low Volatility High Dividend ETF (LVHD). However, CDC easily has the best track record out of the three.

USMV appears to have the edge on both revenue and earnings per share growth estimates, in part because of its allocation to Systems Software stocks like Microsoft (MSFT). However, investors are paying a steep premium: 25.02x forward earnings compared with just 15.80x for CDC. This valuation difference is bolstered by Seeking Alpha’s net value grade for the two ETFs, which I have calculated to be C+ and D+ for CDC and USMV, respectively.

I want to point out that CDC’s 11.31% forward EPS growth rate is still excellent. To be paying just 15.80x earnings for that level of growth is, in my view, a great deal. To illustrate, out of the 107 ETFs I’m tracking that fall in the low volatility, dividend, or value categories, only 32 have a five-year beta among current constituents that’s less than 0.90. Of these 32 ETFs, 23 have double-digit forward EPS growth rates, but the average forward price-earnings ratio on them is 21.51. CDC is one of just four ETFs in the 16x forward earnings range. One happens to be the iShares Core High Dividend ETF (HDV), which has beaten SPY by 11% since I initially recommended it in November. These are the factors that the market is favoring at the moment, so I like CDC’s chances for outperforming even in a rising market.

Investment Recommendation

CDC offers three layers of protection. First, its selection process begins by selecting 100 high-dividend payers. Dividends give investors added flexibility, and with each payment, some risk is taken off the table. Second, the Index is volatility weighted, resulting in a portfolio with a weighted-average beta of 0.85. Most dividend-themed ETFs have betas between 0.90 and 1.00, and even among low-volatility-themed funds, it’s not uncommon to see betas float above 0.90 as more small-cap stocks are included. CDC keeps the large-cap focus and in turn, tends to select higher-quality and more profitable stocks compared to others in the category. Finally, its policy for exiting equities in favor of treasuries when its Reference Index falls more than 8% is an automatic portfolio defender. As we saw in January 2019, the strategy won’t always work, but it did wonders in March 2020 and can allow investors to rest easier. Those are big advantages in my book, which is why I am maintaining my buy rating on CDC, and think it could make a great addition to any conservative dividend investors’ portfolios.