The purpose of this article is to evaluate the iShares Core Dividend Growth ETF (DGRO) as an investment option at its current market price. Since the start of the new year, the market has seen a tremendous move higher, and DGRO has gone up along with it. Despite this positive move, DGRO still trades well below the average S&P 500 company, credited mostly to the fund’s high weighting towards the Financials sector. With the major indices re-testing previous highs, investors may be looking for funds that are not trading at expensive premiums, and DGRO fits this bill. Furthermore, the fund has seen continued dividend growth in the new year, instilling confidence in the underlying portfolio. Finally, the top holdings within the Health Care sector saw another strong quarter to round out the year and continue to illustrate why this sector is one all investors need some exposure to.
First, a little background on DGRO. The fund is managed by BlackRock, and its objective is to “track the investment results of an index composed of U.S. equities with a history of consistently growing dividends.” Currently, DGRO is trading at $36.59/share and yields 2.32% annually, based on its last four distributions. I recommended DGRO during my last review and specifically indicated it would be a smart investment choice in 2019. Since that review, DGRO has returned just under 4.5%, which is a solid performance, especially considering the recent market volatility. As we move deeper in to 2019, I remain convinced DGRO is an attractive investment choice for dividend investors, and I will explain why in detail below.
Dividend Growth Continues
To start, I want to first emphasize that the primary reason for my interest in DGRO is the dividend growth factor. I see dividend growth as a paramount factor for deciding what stocks and funds to buy, so DGRO’s primary focus on dividend growth clearly would peak my interest. This is predominately for two reasons. One, whether interest rates are going up, down, or sideways, dividend growth is attractive because it increases an investor’s income stream. This will help maintain or widen the yield compared to treasuries and helps allow the fund to offer a yield investors find attractive. While a yield just over 2% is not overly impressive, the fact that it is likely to grow (all other things being equal) makes that figure seem more robust. Two, companies that prioritize growing their dividends tell me their management is aligned well with shareholder interests. It also gives me confidence in the cash management abilities of the firm, as well as the expectation that revenue and profits are expected to grow going forward. A company in a declining sector or investment space will have a hard time growing their dividend meaningfully, so a fund that focuses on only those companies which are growing their dividends tells me the underlying portfolio is strong.
With this in mind, we have to be especially critical of the actual dividend growth DGRO delivers. While the objective aligns with my interest, that does not mean the objective is being fulfilled.
Fortunately, DGRO does indeed have a strong track record of dividend growth, especially in the short term. Last year, I touted this metric consistently, and the fund ended the year with almost 15% dividend growth compared to the prior calendar year. Also, importantly, DGRO started 2019 off with similar growth from its Q1 dividend, as illustrated in the chart below:
|Metric||2018 YOY||Q1 2019 YOY|
Source: iShares (with calculations made by Author)
My takeaway here is that 2019 has started off on the right foot for DGRO. The fund has seen capital appreciation, and its dividend growth comfortably exceeds the double-digit threshold. This confirms for me DGRO is meeting its basic objective and is a bullish sign overall.
Below Market Valuation – Helped By Financials
A second key point on why DGRO remains attractive has to do with the valuation. With the market trading at historically high levels, investors who want to remain long in equities may want to look towards stocks and funds that are trading below the market average, as a way to remove some risk. While DGRO is not “cheap”, it does trade at a discount of almost 15% to the broader S&P 500, as illustrated in the chart below:
A key reason for this discount has to do with the exposure to the Financials sector, as this is an area that has been out of favor for some time. With a current P/E of 13, this is helping to bring down DGRO’s average, because this sector makes up a sizable portion of the fund, as illustrated below:
Of course, simply having a cheap valuation does not mean the sector is going to outperform going forward. In fact, it could mean the opposite, if the sector remains out of favor. While I don’t expect Financials to do much more than market perform this year, I do appreciate how some of DGRO’s top holdings are helping keep the price to own the fund down at a reasonable level.
Financials: Some Positive Attributes
Aside from a below market valuation, there are some underlying developments that should help the Financials sector going forward. Specifically, the U.S. consumer continues to have a healthy appetite for debt, with credit balances increasing in Q4 in every category except home equity lines of credit, in a year-over-year comparison, illustrated in the chart below:
Source: New York Fed
When we consider that interest rates also rose last year, along with debt balances, this means consumers are likely paying increasing amounts of interest, which is a net positive for the lenders who are extending the credit. This should improve interest margins and profits for the companies within the Financials sector, many of which are held within DGRO.
Of course, rising debt levels is not always a good sign, especially as rates increase. This is only good news if consumers continue to pay off their debts. Otherwise, the lenders are stuck holding an empty bag. While further interest rate increases have been on hold so far in 2019, debt levels are continuing to climb, and that is something to carefully monitor.
However, I currently view this development as a positive and don’t see a need to panic, yet. Importantly, the employment picture in the U.S. continues to improve, and that is a bullish sign for household’s ability to repay outstanding debt. According to the most recent employment release from the Bureau of Labor Statistics (BLS), the employment rate declined to 3.8% in February, which reversed a two-month trend higher, illustrated in the graph below:
Perhaps even more importantly, earnings also continue to rise. The report noted that average hourly earnings rose to $27.66, representing a 3.4% gain from the prior year. A lack of wage growth had been a sticking point for a long time post-recession, and improvement in this area is a welcome sign.
My overall conclusion here is that rising debt levels, while sometimes viewed as a potential warning sign, appear manageable at this point, given the strength in jobs figures. As consumers increase their borrowing, their ability to pay the debt back becomes of vital importance, but increased wages give me confidence the current, higher debt levels are manageable. This bodes well for Financial firms going forward and should provide a decent catalyst for earnings growth within the sector.
Health Care – Continues To Lead
To wrap up the discussion on DGRO, I want to do a follow-up on three of the largest Health Care stocks within the fund, which are Johnson & Johnson (JNJ), Pfizer Inc. (PFE), and Merck & Co. Inc. (MRK). In my last review, I discussed how Health Care is an area I want to continue to increase my exposure to, and DGRO offers the ability to buy into some of the sector’s biggest names. The three stocks mentioned above continue to make up around 8% of the fund, so their performance is of particular interest to DGRO investors.
In my November review, I noted how each company was performing fairly well, based on their Q3 earnings reports and also how the outlook for the sector at large was positive. In hindsight, Health Care indeed continued to do well, ending 2018 as the top performing sector of the market for the entire year. Furthermore, the performance of the individual holdings I mentioned above also was strong in Q4. In some cases, the earnings showed an acceleration in growth compared to Q3, as the table below indicates:
|Company||Revenue Gain Q3 (YOY)||Revenue Gain Q4 (YOY)||Adjusted Earnings Gain Q3 (YOY)||Adjusted Earnings Gain Q4 (YOY)||Most Recent Dividend Increase|
Source: Seeking Alpha Earnings Reports
My takeaway here is fairly positive. I see that all three of the companies are performing reliably well, with meaningful dividend growth as an added bonus. My outlook continues to be positive for this sector as a whole, and the Q4 earnings cycle reaffirms the basis for that position.
Now that 2019 is underway, I revisited my top dividend ETF holding for the prior year to see if it continues to warrant a large weighting in my portfolio. After review, DGRO remains one of the few funds I plan on adding to, especially in the short term. The recent dividend growth is encouraging, and the fund’s valuation gives me some comfort, especially since the market is trending back towards all-time highs. With Financials, Information Technology, and Health Care making up the top three largest sectors of the fund, DGRO is well diversified and offers investors exposure to both offensive and defensive plays. At these levels, I am getting especially selective about which funds I buy, but DGRO continues to offer value, and I remain convinced this is a fund investors should consider at this time.
Disclosure: I am/we are long DGRO, SPY. 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.