IDV: International Dividend Stocks Are Undervalued (BATS:IDV)

iShares International Select Dividend ETF (BATS:IDV) is an exchange-traded fund with exposure to international stocks with relatively strong historical dividend yields. The expense ratio is 0.49% which is not cheap but in line with similar macro ETFs. The 30-day SEC yield is calculated as being 5.91% as of April 29, 2022. The twelve-month trailing yield was 5.66%.

As illustrated below, IDV’s top country exposures are the United Kingdom (21%), South Korea (9%), Australia (8%), Spain (8%), Japan (7%), and also various other countries including Italy, Canada, Hong Kong, France, etc.

Key sector exposures, shown below, include Financials (28%), Industrials (16%), Utilities (16%), and Materials (15%). Others include Energy, Consumer Discretionary, Communication, Real Estate, etc.

IDV is basically exposed to mature businesses in mature markets and sectors, with typically moderate returns on equity and higher-than-average dividend distribution rates. The greater the proportion of returns that are derived from dividend distributions, the lower the returns typically found from price appreciation. IDV’s price action over the long haul is as illustrated below.

So, since inception, IDV is actually down on a price-only basis, and the share price is currently the same as it was in, for example, September 2009.

Nevertheless, it is possible to value the portfolio. It is best to err on the side of being conservative though. IDV seeks to replicate its chosen benchmark, the Dow Jones EPAC Select Dividend Index (factsheet available here). Based on a recent factsheet as of April 29, 2022, IDV’s benchmark’s trailing price/earnings ratio was 7.18x, and its forward price/earnings ratio was 6.74x (as projected). The benchmark index’s price/book ratio was 1.12x. That implies a forward return on equity of 16.6%, which is actually pretty strong.

The indicative dividend yield is reported as 7.35%, against a trailing earnings yield of 13.93%. So, dividing the former into the latter gives us an implied distribution rate (of earnings) of about 53%. It is something to work with anyway. Although we can start with a high return on equity of over 16%, let’s assume that tails off to 14% (on average) over the course of five years or so. If earnings are distributed at the rate of about 50%, our return on equity profile basically results in earnings growth of around 3-7% on average (but turning down toward the end of the forecast horizon, as follows). BV in the table below stands for Book Value, implied by the share price of IDV and the price/book ratio offered by its benchmark as of April 29, 2022.

At year five, we could assume a longer-term risk-free of 3% (this compares to the current U.S. 10-year yield of 2.74%, which we can use as a proxy for the risk-free rate for the moment) and an equity risk premium of between 4.2% and 5.5%. That means our cost of capital is between 7.2 and 8.5%. Even if we priced zero growth into earnings beyond the terminal year (and thus did not reduce our cost of capital in our terminal value calculation), we could still arrive at a terminal value of at least $64.54. That would be a forward price/earnings ratio in year five of 11.76x, higher than the current one of about 6.74x, but still relatively low. But let’s assume an even lower forward price/earnings ratio of 6x in year five (terminal value: $32.92). We get an IRR of over 16% per annum on this basis.

The IRR drops to 8.51% if you only include dividends distributed, which is neatly close to our 8.5% cost of capital estimate (at the top of our range). Still, if we value the aggregate of IDV’s earnings power, and not just dividends available for distribution, IDV is likely undervalued. The above calculations are also based on a large forward earnings yield in year five of almost 17% (i.e., a low terminal value of just $32.92, barely higher than the present share price). Without material benchmark-driven rebalancings, IDV is likely cheap at present prices.

At the very least, even if you assume that the market continues to price IDV’s holdings in aggregate as just dividend distributors, risk-averse investors should probably feel safe from material price declines at IDV’s present share price. If anything I think an upward revision to the share price makes sense.

My calculations do not include buyback distributions; if we raised our distribution rate from 50% to 60% for instance, this would mean that our average returns on equity in nominal terms would fall (since the companies would be retaining less earnings, and thus generating lesser nominal earnings power on those retained earnings, if percentage returns are kept the same). Still, our IRR would still be 14.57% in this scenario.

Also, my estimates imply a forward five-year average earnings growth rate of 3.54%. Morningstar’s three- to five-year earnings growth estimate for IDV’s portfolio is currently 6.59%. No matter where we are in the business or investment cycle, I think IDV (international dividend stocks) are cheap.