DGRO: Market Returns Plus Double-Digit Dividend Growth (NYSEARCA:DGRO)

Investment Thesis

The iShares Core Dividend Growth ETF (DGRO) is for the long-term investor who wants a high dividend yield in the future but doesn’t necessarily need one today. While its 2.01% yield isn’t anything to get excited about, its double-digit growth rate is, and I’m happy to report that I expect this growth will continue based on my analysis of current holdings.

DGRO achieves this growth primarily because it excludes several high-growth, highly-valued, and zero-dividend-paying stocks in the S&P 500. This contrasts with the assumption that it selects the strongest dividend growers. Still, because of these exclusions, DGRO investors end up with a more value-oriented portfolio that costs 7x less forward earnings while sacrificing an acceptable amount of growth. My current view is that since DGRO is more value-oriented, it will outperform the market, but it won’t be anything substantial. Therefore, I suggest holding DGRO for its strong dividend growth rate and defensive lean, and I look forward to explaining why in more detail in this article.

DGRO Overview

Strategy & Fund Basics

DGRO benchmarks against the Morningstar US Dividend Growth Index and reconstitutes annually in December, leaving us with a fresh set of holdings to analyze today. Constituents must have five years of uninterrupted annual dividend growth, an estimated dividend payout ratio of less than 75%, a positive consensus earnings forecast, and distribute qualified income only, so no REITs are allowed. One additional distinction is that the Index excludes the top 10% of dividend-yielding securities. My research shows that such stocks almost always underperform in the long run, so I’m happy with this simple but effective screen.

The Index is dividend-dollar-weighted, meaning a security’s allocation is the product of its outstanding shares and its dividend per share. This means a security could have a considerable weight even if its dividend yield is small, so long as its shares outstanding is large enough. For this reason, you’ll find mega-caps Apple (AAPL) and Microsoft (MSFT) in the top ten, even though their yields are tiny at just 0.52% and 0.80%. Before getting to DGRO’s composition, let’s first go over some of the fund’s basics that I’ve listed below for quick reference.

• Current Price: $53.32
• Assets Under Management: $22.06 billion
• Expense Ratio: 0.08%
• Launch Date: June 10, 2014
• Trailing Dividend Yield: 2.01%
• Three-Year Dividend CAGR: 9.77%
• Five-Year Dividend CAGR: 10.30%
• Five-Year Beta: 0.94
• Number of Securities: 400
• Portfolio Turnover: 31.00%
• Assets in Top Ten: 25.09%
• 30-Day Median Bid-Ask Spread: 0.02%
• Tracked Index: Morningstar U.S. Dividend Growth Index

As shown, DGRO has $21.71 billion in assets under management and a low 0.08% ratio. It has nearly as many holdings as the S&P 500 and has about the same percentage of assets in the top ten, but the 2.01% trailing yield is unlikely to be a selling point. However, DGRO’s strong suit is that it selects only dividend growers rather than the entire U.S. large-cap market. This strategy ensures a solid long-term dividend growth rate, and since the majority of S&P 500 companies are dividend growers, investors should still get some solid market exposure, too.

Sector Exposures & Top Holdings

Unlike the S&P 500, DGRO’s primary exposure is in the Financials sector, though it still has a healthy 18.90% allocation to Technology stocks. Perhaps this is a little too high given how Vanguard is projecting negative returns for U.S. growth stocks over the next decade, but DGRO does overweight more defensive sectors like Health Care and Consumer Staples. One negative is its exclusion of the Real Estate sector and its negligible allocations to Energy stocks. These two sectors can provide significant returns in today’s high inflation environment, so complementing DGRO with targeted sector ETFs is recommended.

Johnson & Johnson (JNJ) is the fund’s top holding, as it’s performed well since the December 17, 2021, rebalancing. Pfizer (PFE) is next, followed by Procter & Gamble (PG), Microsoft, and Apple. Together, these top ten holdings account for 25.09% of DGRO.

Historical Performance & Dividend History

Since its inception, DGRO has performed almost as well as the iShares Core S&P 500 ETF (IVV). After trailing through the majority of the pandemic, it lost less in the recent market selloff. DGRO’s annualized standard deviation was slightly less, resulting in better risk-adjusted returns as measured by the Sharpe Ratio.

Turning to dividends, DGRO has produced larger and faster-growing dividends than IVV. An investor with $10,000 would have received $264 in dividends in 2015. That figure would grow to $505 in 2021 compared to just $334 for IVV. DGRO’s yield of 2.01% may not work for investors needing income today but should appeal to dividend investors with longer time horizons.

Finally, the graph below shows how DGRO’s yield remained relatively constant despite the growing dividends. There was one brief opportunity in March 2020 when the yield rose above 3%, but this was mainly due to depressed prices.

Fundamental Analysis

Snapshot By Industry

Instead of examining DGRO’s top 20 companies, which would only cover about 40%, we can learn more by looking at the top 20 industries, which total nearly 70%. Now, we can see that low-risk Pharmaceuticals stocks like Johnson & Johnson, Pfizer, and Merck (MRK) are balanced out by more volatile positions in the Diversified Banks industry. Such holdings include JPMorgan Chase (JPM), Bank of America (BAC), and Citigroup (C) and should prove crucial should the Federal Reserve makes good on its interest-rate-hike plans.

The metrics below were chosen to assess DGRO’s growth prospects, valuation, and market sentiment direction. I watch earnings reports for market sentiment direction and how well companies performed against analyst expectations. In between earnings reports, Seeking Alpha’s EPS Revisions Grade can help explain why a stock is moving a certain way when seemingly its fundamentals haven’t changed.

First, some may be surprised that even DGRO is more concentrated than IVV (68.67% vs. 60.69%) at the industry level. Despite avoiding many mega-cap growth stocks like Tesla (TSLA) and Netflix (NFLX), much of DGRO’s returns still will be heavily influenced by Pharmaceuticals, Banks, Semiconductors, Soft Drinks, and Household Products stocks. In my view, DGRO doesn’t necessarily have a diversification advantage.

However, one clear advantage is DGRO’s 0.94 five-year beta, indicating its holdings have experienced less-than-average volatility in the last five years. Also, its forward price-earnings ratio is about 7x lower, which is a nice discount for the growth investors are giving up. On the revenue side, analysts expect 8.57% growth over the next twelve months alongside 14.93% growth in earnings per share. Quarterly revenue surprises, Profitability Grades, and EPS Revisions Grades are identical for the two ETFs, so I view the two similarly regarding sentiment. A caveat is that value stocks appear to have less earnings risk, benefiting DGRO more. I’ll touch on that next.

Snapshot By Company

As mentioned earlier, DGRO produces a higher dividend growth rate primarily due to its exclusion of non-dividend-paying stocks. Interestingly, the reason is not due to its selection of the strongest dividend growers. In fact, the opposite is true. I’ve highlighted selected dividend metrics for DGRO’s top 20 companies as well as metrics for dividend-paying companies in the S&P 500. About 76% of S&P 500 companies by weight pay a dividend, so readers could deduce that the forward dividend yield for IVV is about 1.43% (1.88% x 76%).

This comparison allows us to see that dividend-paying stocks in the S&P 500 have better three- and five-year dividend growth rates, albeit slightly. The forward yield of 2.18% is somewhat higher, though. My interpretation is that DGRO tends to hold more mature companies that pay higher dividends but grow them slower. However, the differences are negligible, and I don’t see either ETF having an advantage in this regard.

Instead, what will drive short-term returns is how the current earnings season progresses. As shown above, IVV’s stocks surprised by 9.08% on earnings compared to just 6.75% for DGRO for the most recent quarter reported. According to Seeking Alpha, only 152 S&P 500 stocks have reported this January, and after adjusting out Real Estate securities (where less emphasis is placed on EPS), the average surprise was only 7.13%. Therefore, the trend is downward, suggesting that high P/E stocks that haven’t been reported have a lot of earnings risk right now. Think Amazon (NASDAQ:AMZN) and Walt Disney (DIS), two stocks DGRO excludes that have forward P/E ratios of 70.51 and 34.18, respectively. They both badly missed earnings expectations last quarter, and analysts have largely revised current quarter estimates downward. I believe that to miss estimates again would be devastating for these stocks, so investors could benefit from a fund like DGRO because its P/E ratio is relatively low at just 19.69x earnings.

Investment Recommendation and Conclusion

I continue to view DGRO positively, but its advantages over the S&P 500 and, more specifically, dividend-paying stocks in the S&P 500 are unclear. Its double-digit dividend growth rate is terrific, but it’s primarily due to excluding non-dividend-paying S&P 500 stocks, an Index where double-digit growth is the norm. It’s possible dividend growth investors could benefit further with a more focused fund like the Schwab U.S. Dividend Equity ETF (SCHD).

Still, I see no reason to sell DGRO right now. While it likely will underperform if a bull market returns, I see evidence of value stocks outperforming in the near term. DGRO’s lower price-earnings ratio should help protect it against big shocks caused by poor earnings reports. In summary, my recommendation is to hold DGRO for now and continue to lean into value and dividend-themed ETFs until market sentiment turns positive again.