FDIV: 2.78% Yielding Dividend ETF With Questionable Quality And Growth (NASDAQ:FDIV) #NewsETFs

Investment Thesis

Initially, I was excited when asked to review the MarketDesk Focused U.S. Dividend ETF (NASDAQ:FDIV). Its fund page describes a concentrated portfolio of S&P 500 Index (SP500) stocks with a 3% indicated annual dividend yield and a median ROE that’s 8% better than its broad-market benchmark. However, my fundamental analysis revealed that FDIV’s selections have surprisingly weak free cash flow margins and negative free cash flow growth, raising red flags about FDIV’s selections’ ability to generate cash. As comparators, I will contrast FDIV with the iShares Core Dividend ETF (DIVB), the Schwab U.S. Dividend Equity ETF (SCHD), and the Vanguard High Dividend Yield ETF (VYM). I will explain why I believe all of these are superior, and ultimately, use them to justify my “sell” rating for FDIV. I hope you enjoy the read.

FDIV Overview

Strategy Discussion

According to its methodology document, FDIV begins with a universe of approximately 1,000 dividend-paying stocks with market caps above $1 billion. From this universe, the strategy eliminates REITs, stocks with dividend yields below 1.75%, stocks with average daily volumes less than $25 million, and finally, stocks with free floats less than 40% of total market cap. While this part of the selection process is transparent, it’s unclear how the remaining stocks are ranked, as MarketDesk relies on its proprietary Dividend Composite Score to group stocks into two categories:

• High Yield Dividend Growth (Top 50)
• High Yield Dividend Stability (Top 50).

Each stock is equally weighted at 1%. However, stocks can be members of both groups, in which case their starting position weight is 2%, with a maximum 35% allocation per sector. Typically, 60-80 dividend stocks that also offer a high potential for capital appreciation are selected, with the fund’s prospectus adding some additional color, as follows:

• The fund is actively managed and reconstitutes monthly.
• The sub-adviser employs quality screens based on financial statement metrics like return on equity and cash flow to debt.
• The sub-adviser evaluates each company’s dividend payment history, growth, and consistency over the past five years.

The prospectus also notes how

“a security is considered to have the potential for capital appreciation when it trades at a price below the price at which the Sub-Adviser believes it would trade if the market reflected all factors relating to the company’s worth.”

After reading this, my expectations for FDIV’s growth potential diminished, as the statement merely defines a capital gain and doesn’t describe how to generate one.

Lastly, after reviewing hundreds of U.S. Equity ETFs on Seeking Alpha, I’ve learned that fund providers only highlight the metrics they want you to focus on. In FDIV’s case, it’s dividend yield and return on equity. According to the graphic below, FDIV’s portfolio had a 3.0% indicated dividend yield and a median 23% return on equity, 8% better than the median of the S&P 500 Index. The implication that FDIV is high-yielding and high-quality is strong.

However, return on equity is just one measure of qualityand it is incomplete. ROE does not evaluate a company’s overall capital structure, which can be boosted through leverage (DuPont Analysis), and typically only works for mature companies with minimal reinvestment needs. It’s best to complement it with other metrics like return on assets, return on total capital, net income margins, and free cash flow margins to identify any disconnects. MarketDesk might do that, but the fact they only highlight ROE indicates FDIV might score poorly on other profitability metrics.

Sector Exposures and Top Ten Holdings

One of FDIV’s distinguishing features is its 26.67% exposure to the Consumer Staples sector, whereas DIVB, SCHD, and VYM have exposures of 7.75%, 14.78%, and 13.25%, respectively. FDIV also overweights Materials at 11.14%, with key offsets in Financials and Technology.

FDIV’s top ten holdings are listed below, totaling 21.49% of the portfolio. The Clorox Company (160) leads the way due to its solid earnings beat at the start of the month. The stock is up 5.30% in the last month but remains underwater by 9.64% over the last five years (excluding dividends).

FDIV Fundamental Analysis

The following table highlights selected fundamental metrics for FDIV’s top 25 holdings, totaling 51.91% of the portfolio. All these stocks have weights around 2%, indicating they were selected for their dividend growth and dividend stability features.

From this summary, we can conclude that FDIV:

1. Assigns larger weights to smaller stocks, based on its $59B market cap.
2. Is about as volatile as its peers, per its 0.94 five-year beta.
3. Has flat estimated sales and earnings per share growth.
4. Trades at a competitive valuation (14.90x forward earnings).
5. Yields 3.13% before fees (Index yield).
6. Has weak earnings momentum (4.99/10 EPS Revision Score).
7. Has poor profitability features (8.21/10 Profit Score).

I want to focus on four factors: dividends, growth, value, and quality. FDIV’s Fact Sheet indicates that its innovative strategy aims to solve investors’ yield vs. capital appreciation dilemma, but the above summary raises a few red flags that require a deeper dive. Let’s start with dividends.

FDIV Dividend Analysis

FDIV’s selections have a weighted average 3.13% yield. After subtracting the fund’s 0.35% expense ratio, shareholders should net 2.78% at current prices. It isn’t too bad, but since DIVB, SCHD, and VYM have low fees, shareholders come out ahead at 3.07%, 3.86%, and 2.87%, respectively.

This table, summarized by sub-industry, also highlights that FDIV’s selections yield far above their 2.51% four-year average. For example, its Packaged Foods & Meats stocks (MDLZ, HSY, HRL, LW, MKC, FLO) yield 2.85% compared to their 2.07% four-year average, while the gap for Oil & Gas E&P stocks is even larger (4.67% vs. 3.77%). Higher payout ratios are partially to blame, as the fund’s ratio sits at 48.44% compared to the 43.04% four-year average. However, FDIV’s selections also have excellent dividend growth track records. On average, they are on 20.75-year growth streaks and have grown dividends by an annualized 11.27% over the last five years.

FDIV’s dividend safety and dividend growth metrics are superior to DIVB, SCHD, and VYM. However, the sector-adjusted scores listed at the far right of the table indicate it’s mostly due to FDIV’s unique composition. FDIV’s 7.25/10 dividend safety score is below DIVB and VYM’s score, while its 7.56/10 dividend growth score is behind DIVB and SCHD’s score. I prefer these scores, as they are based on Seeking Alpha Factor Grades that rank companies on multiple dividend metrics against their sector peers.

The bottom line: FDIV is competitive on dividends, but certainly no better than these low-cost alternatives.

FDIV Growth and Value Analysis

Next, I want to look at growth and value. The initial summary noted 0.85% and -0.62% estimated one-year sales and earnings growth rates, which surprised me, as it indicates the main source of capital appreciation is the undervaluation of its selections. That could be true, but it’s similar to how other value strategies work, and based on FDIV’s 14.90x forward P/E, it’s not more discounted than its peers. Here are a few additional growth and value metrics to consider, and I want to emphasize the negative three-year free cash flow growth rates for 25/61 holdings, whose weights total 42.98% of the fund.

The net result is a -2.55% three-year free cash flow growth rate, with significant weaknesses in FDIV’s Consumer Discretionary and Industrials selections. SCHD and VYM are superior on this metric, and in VYM’s case, it at least offers 3-5% sales and earnings growth. I like these better-balanced funds, and since VYM’s dividend and value metrics are as strong or better than FDIV’s, it’s the better choice.

FDIV Quality Analysis

Lastly, I want to highlight the considerable difference between FDIV’s return on equity and free cash flow margins. As discussed earlier, relying on ROE has several limitations, and although FDIV’s model supposedly considers many data points, it’s difficult to believe free cash flow margins are assigned much weight. As shown below, margins are just 8.82%, whereas FDIV’s weighted average ROE is 25.71%.

The table reveals FDIV’s 0.87 weighted average asset turnover ratio (sales/assets) as the main reason for its high ROE. This is normal, as FDIV has 26.67% allocated to Consumer Staples, and the Consumer Staples Select Sector SPDR ETF (XLP) has the highest asset turnover ratio (1.35) among all large-cap sector funds. However, FDIV’s 13.84% net margins are about 2-3% less than its peers, and its implied financial leverage is on the high side. Moreover, FDIV’s 8.21/10 sector-adjusted profit score ranks #97/109 in the large-cap value category, which highly suggests it’s not nearly as high-quality as MarketDesk indicates.

Investment Recommendation

FDIV is a 2.78% yielding dividend fund with a 0.35% expense ratio and solid dividend consistency, growth, and safety features. However, I was surprised to learn many of its holdings have flat or negative sales, earnings, and free cash flow growth rates, despite a suggestion from MarketDesk that these stocks have decent growth potential. I was also disappointed that FDIV has poor overall quality despite impressive ROE metrics, which I traced to a high asset turnover ratio from 27% exposure to the Consumer Staples sector. Naturally, if this sector outperforms, so too will FDIV, but I don’t believe FDIV can compete well with low-cost peers like DIVB, VYM, and SCHD, all of which offer better combinations of dividends, value, growth, and quality. Therefore, I recommend readers avoid FDIV, and I have assigned it a “sell” rating. Thank you for reading, and I look forward to your comments below.