Schwab SCHD ETF: A Great Dividend Growth Pick

Article Thesis

Schwab Strategic Trust – Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD) is a well-managed dividend growth ETF that has a strong track record and that promises an attractive combination of yield, income growth, and resilience, making it look compelling for income and dividend growth investors looking for a lower-risk addition to their portfolios.

What Is Schwab Strategic Trust – Schwab U.S. Dividend Equity ETF?

Schwab Strategic Trust – Schwab U.S. Dividend Equity ETF surely has a complicated name, but it’s not really hard to explain what the ETF does. It seeks to replicate the performance of the Dow Jones U.S. Dividend 100 Index. This index, in turn, invests in US-based high-yielding equities that have strong quality metrics relative to their respective peers when it comes to financial health and similar fundamental metrics.

The fund itself notes its strategy and some of the advantages of the fund in its fact sheet:

When it comes to the noted highlight of low costs, SCHD delivers. Its expense ratio is just 0.06%, which is at the lower end of what ETFs generally charge. With an expense ratio this low, even a 10-year or 20-year time horizon will not result in meaningful losses versus a no-expense investment — over a decade, total cumulated expenses are still way below one percentage point and therefore, I believe, relatively negligible.

SCHD’s statement that the fund may serve as the core of a portfolio, or be part of a diversified portfolio, makes sense to me. Since SCHD itself is well-diversified across dozens of companies from different industries and market capitalization ranges, it may very well serve as the core of a portfolio — while putting too much money (or, more precisely, a too-large relative allocation) into a single stock is risky, SCHD’s internal diversification means that putting a larger share of one’s portfolio into SCHD isn’t overly risky. Of course, there’s still market risk, but that can’t be diversified away anyways.

Due to the value/dividend nature of SCHD’s holdings, its volatility isn’t very pronounced. Growth stocks, especially unprofitable growth stocks, which aren’t included in SCHD, tend to be more volatile versus the large-cap blue chip income stocks SCHD invests in. One can thus expect that SCHD will be less volatile than the broad market during times of turmoil. That has also held true this year. SCHD has declined by 6.5% so far this year, which makes for a total return of around -3% once we account for SCHD’s dividend payments. The broad market index S&P 500 (SPY), meanwhile, has offered a total return of -18% in 2022, while the tech-heavy Nasdaq index (QQQ) has returned -33% in 2022, accounting for dividends.

The below-average volatility and resilience versus market downturns is a key advantage of SCHD. Combined with the above-average dividend yield and reliable income growth that we have seen since inception, this makes SCHD a suitable choice for conservative income investors that want to own a sleep-well-at-night income investment vehicle.

Looking at SCHD’s key holdings, we see the following names:

Merck (MRK) is the largest holding as of the end of September. It’s also been the best-performing large-cap pharma name in 2022, on the back of strong progress with its mega blockbuster drug Keytruda. Pfizer (PFE), PepsiCo (PEP), Amgen (AMGN), and Coca-Cola (KO) are also among the ETF’s top 10 investments. The non-cyclical, resilient nature of the business models of these pharma and consumer staple companies means that SCHD won’t be very vulnerable versus a potential recession or economic downturn in 2023. There are some tech names in the ETF’s top holdings list as well, such as International Business Machines (IBM) and Texas Instruments (TXN). While tech names tend to be more volatile both when it comes to underlying profits as well as when it comes to their share price performance, these two names are rather inexpensive and are thus not hit too hard when discount rates rise — relative to other tech names that have performed poorly in the recent past, such as Amazon (AMZN):

In the above chart, we see that TXN trades well below the long-term median earnings multiple. IBM is slightly more expensive than it was, on average, over the last decade — but IBM isn’t trading at a very high valuation, thus its downside potential should be limited.

In the above table, we see some characteristics of the ETF and its combined holdings. The earnings multiple is pretty low, at just 13x 2022’s net profits. Since some earnings growth can be expected for the current year, 2023, the earnings multiple might be even lower. That compares favorably versus the broad market’s valuation in the high-teens range. This is the result of the way the Dow Jones U.S. Dividend 100 Index chooses its members — fundamentals, including valuation, are considered. SCHD does, thus, usually not invest in highly-valued or overvalued equities, which helps keep the average valuation of its holdings at a reasonable level. That, in turn, also allows for some downside protection during equity market downturns, as inexpensive equities don’t fall too much during market downturns.

The price to cash flow ratio is even lower, at just 9x. That translates into a cash flow yield of around 11% — the dividend of the average SCHD holding is thus very well covered.

Despite these value characteristics, SCHD’s average holding has experienced highly compelling earnings growth in the recent past. Over the last five years, which includes the pandemic, SCHD holdings have grown their profits by 12% a year on average. With a starting dividend yield of more than 3%, that makes for a highly compelling dividend growth choice. Even if the earnings growth of the average SCHD holding would drop by half going forward, to around 6% a year, investors might still expect total returns of 9% or so per year, as the combination of a mid-single-digit earnings growth rate and a 3%+ dividend yield should allow for high-single-digit returns.

SCHD: High Yield And Compelling Total Returns

Based on the current payout, SCHD offers a dividend yield of 3.4%. That’s around two times as high as the broad market’s dividend yield today. While SCHD is not an ultra-high-yield investment, its income yield is compelling, I believe, especially when we consider the dividend growth and the resilience and low-risk nature of the dividend payments the ETF makes.

In the above table, we see SCHD’s dividend growth over the last decade. While annual dividend growth wasn’t perfectly even, dividends went up every year. Even during the worst years, 2017 and 2018, SCHD still delivered 7% dividend increases, respectively.

The more telling average growth rate is well north of 10%, with SCHD growing its dividend by at least 11% in four out of the last four quarters. History doesn’t repeat itself, but it rhymes — it would thus not be too surprising to see SCHD deliver comparable dividend growth in the coming years as well. But even if dividend growth drops considerably — which hasn’t been the case during the pandemic, for example — SCHD could still deliver compelling total returns.

Even a dividend growth rate of just 5%, when combined with a dividend yield of 3.4%, would be reasonably attractive, as this would allow for total returns in the 8% range in the long run. Combine this with diversification and below-average volatility, and SCHD would be a reasonable long-term holding even if its future dividend growth rate falls way short of the dividend growth the ETF has achieved since inception. If dividend growth in the coming years is anywhere close to what the ETF has achieved in the past, investors could be looking at total returns in the 10%-15% range going forward — which would be highly attractive, especially when we consider the below-average volatility of the ETF versus the broad market.

Since inception, SCHD has outperformed the broad market slightly:

SCHD is up 324% since inception, while SPY has delivered returns of 294% over the same time frame. And yet, the maximum drawdown of SCHD is slightly smaller, at 33%, versus 34% for SPY over the same time frame. Above-average returns in combination with below-average risks are compelling for investors, of course.

Takeaway

SCHD is an ETF that combines many positives. It has a strong track record when it comes to dividend growth and total returns, it’s not very volatile and tends to outperform the market during downturns, and it offers a compelling dividend yield.

For income investors looking for a buy-and-hold, sleep-well-at-night dividend growth pick with built-in diversification, SCHD looks like a good choice, I believe.