DGRW: December Reconstitution Makes For An Unhappy New Year

Investment Thesis

On December 14, 2022, the tracking index for the WisdomTree U.S. Dividend Growth ETF (NASDAQ:DGRW) reconstituted, resulting in a lower-yielding portfolio with less earnings momentum. I expect DGRW’s dividend yield to fall below 2% going forward, and the changes favoring large Technology stocks instead of more defensive ones were disappointing. Therefore, I don’t suggest adding DGRW to your portfolio now, but I will provide the fundamentals for two alternative dividend growth ETFs I feel are better positioned.

DGRW Overview

Strategy and Key Exposures

DGRW tracks the WisdomTree U.S. Quality Dividend Growth Index, selecting approximately 300 U.S. companies with acceptable long-term earnings growth and three-year return on assets and equity characteristics. Constituents are weighted based on their aggregate future one-year cash dividend payments, providing the index a large-cap bias, since larger companies tend to have more free cash to distribute. For instance, after this month’s reconstitution, Microsoft (MSFT) and Apple (AAPL) are DGRW’s largest holdings. Their indicated dividend yields are only 1.15% and 0.51%, respectively. However, the top ten holdings listed below include other high-payers like Philip Morris (PM) and Broadcom (AVGO), which yield 4.95% and 3.32%. The Index applies a 7% individual cap before considering sector caps, which I’ll discuss next.

DGRW’s sector exposures are below. It’s heavy on Technology stocks, which total 26.04% of the portfolio. Consumer Staples follow at 17.84%, while Health Care, Industrials, Financials, and Consumer Discretionary exposures are above 10% each. The Index limits sector exposures to 20%, except for Real Estate, which has a 10% cap. Unfortunately, there’s very little inflation protection via the Materials and Energy sectors, and its defensive qualities look limited by just a 0.59% exposure to Utilities stocks.

Performance and Dividends

DGRW’s track record is excellent. Since its May 2013 launch, it’s delivered a 12.07% annualized return compared to 11.19% for the SPDR S&P 500 ETF (SPY). The SPDR S&P 500 Value ETF (SPYV) only gained 9.23% per year and, surprisingly, had higher volatility. Generally, DGRW has done a nice job keeping pace with the market in bull markets and offered better protection in market corrections.

Even though DGRW focuses on “growth” and not “dividend growth,” shareholders reinvesting dividends from the beginning would generate $638 in portfolio income in 2022 on a $10,000 investment.

DGRW’s Seeking Alpha Dividend Grade is B+, weighed down by its low 2.17% trailing yield. The 12.95% five-year growth rate is much higher than the 6.88% three-year growth rate because of a considerable increase in 2018. The five most recent annual increases from 2018-2022 were 29.29%, 10.44%, 3.24%, 12.57%, and 10.77%.

DGRW Reconstitution Recap

WisdomTree provides the following pre- and post-reconstitution summary of its top ten holdings changes. At the time, the most significant change was a 3.09% increase in exposure to Microsoft. Broadcom, Walmart (WMT), and Morgan Stanley (MS) were new additions with current weights of 2.43%, 2.03%, and 1.75%, respectively.

Raytheon Technologies (RTX) and Comcast (CMCSA) were the key deletions, with previous weightings of 1.46% and 1.27%. Meanwhile, the Index slashed exposure to Merck & Co. (MRK) and Altria Group (MO) by about 1.50% each. These collective changes did little to improve the portfolio’s value or quality features. My fundamental analysis confirms this, as does the following factor summary from WisdomTree.

According to WisdomTree, exposure to the value and quality factors remained about the same pre-to-post reconstitution. However, the percentage of “good” momentum stocks decreased from 60.7% to 49.5%, indicating that the Index now favors more recent poor performers. WisdomTree ranks companies on the momentum factor based on their risk-adjusted six- and twelve-month returns. To visualize what this means, consider the 2022 Sharpe Ratios for DGRW’s 20 largest additions, keeping in mind that DGRW’s 2022 Sharpe Ratio was -0.31.

For companies with scores better than -0.31, like AVGO, WMT, and MS, it’s reasonable to assume that the momentum screen at least played a part in their qualifying this year. However, now is a good time to remind readers that constituents aren’t weighted by their value, quality, and momentum factors. Regardless of their strength on these factors, what matters most is dividend yield and size. A key example is Microsoft, down 28.88% YTD with a terrible -1.35 Sharpe Ratio.

DGRW Analysis

The following table compares DGRW’s fundamentals pre- and post-reconstitution for its top 25 holdings. For comparison purposes, I’ve included the same metrics for the iShares Core Dividend Growth ETF (DGRO) and the Schwab U.S. Dividend Equity ETF (SCHD). DGRO also reconstituted this month, while SCHD’s annual reconstitution is scheduled for March.

As indicated previously, DGRW’s value and quality factors remained similar post-reconstitution. The current portfolio trades at 20.68x forward earnings compared to 20.62x before. Furthermore, the two portfolio’s profit scores are 9.53/10 and 9.52/10. These scores were calculated using Seeking Alpha’s Profitability Grades, normalizing them on a ten-point scale and weighting them accordingly. DGRW has always been a high-quality ETF, but DGRO and SCHD also score well at 9.28/10 and 9.35/10.

Unfortunately, the other factors listed indicate that DGRW moved sideways or negatively post-reconstitution. Its five-year beta increased from 0.87 to 0.92, meaning less downside protection is expected. Some readers may view this positively, but dividend investors tend to be conservative, so I think this is a disappointing move for most. Still, sales, earnings, and dividend growth were effectively unchanged. DGRW trades at a sizable premium to DGRO and SCHD on forward earnings, and its expected gross dividend yield is only 2.26%. After subtracting its relatively high 0.28% expense ratio, investors will net about 2% at these prices. DGRO and SCHD have higher gross dividend yields, lower expense ratios, and similar dividend growth, so they’re far superior now for dividend investors.

Finally, WisdomTree’s price momentum change is consistent with current analyst sentiment. Seeking Alpha provides EPS Revision Grades for nearly all U.S. equities, summarizing professional analysts’ earnings revisions over multiple periods into a single grade. Notice how DGRW’s EPS Revision Score fell from 5.43/10 to 5.16/10, making it no better than a standard S&P 500 Index ETF from an earnings momentum perspective. Specifically, 30/30 Wall Street analysts downgraded Microsoft’s upcoming quarterly earnings over the last three months. For Apple, 23/25 analysts did the same.

Suggestion: Use DGRO And SCHD Together

Some readers may still like DGRW because of its solid track record. Also, the addition of Technology stocks could be viewed as buying high-quality stocks at a discount. This could be true, but it’s an unnecessary risk. As an alternative, holding DGRO and SCHD in equal weight creates a nicely-diversified portfolio, with no sector controlling more than 20%. Pfizer (PFE), Broadcom, and Home Depot (HD) are the only companies with a 3% allocation or more, as detailed in the following table.

The fundamentals of this combined portfolio look nice, too. I’ve summarized the same metrics for its top 25 industries below. Low-risk Pharmaceutical, Soft Drink, and Biotechnology stocks complement riskier offerings in the Semiconductor and Regional Bank industries. The portfolio trades at a 3.61-point discount on forward earnings, has a better EPS Revision Score, and will yield close to 3% after fees with the same double-digit dividend growth. DGRO and SCHD only have a 23% overlap by weight, which helps explain why its top 25 industry concentration is less than DGRW’s (76.92% vs. 78.82%).

Investment Recommendation

DGRW’s annual reconstitution was disappointing, as the changes resulted in higher allocations to Technology companies with negative earnings momentum. In addition, DGRW’s beta increased, sales and earnings growth potential remained the same, and its expected dividend yield fell to 2%. DGRO and SCHD look superior right now, and for those looking to efficiently corner the dividend growth market, owning them both in equal weight will get the job done. Thank you for reading, and I look forward to discussing these ETFs further in the comments section below.