(PUB) Investing 2016

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11 Morningstar FundInvestor September 2016
Funds that focus on higher-quality fare, or, more
specifically, companies that steadily increase their
dividend payouts, have often held up well in tough
times. This was particularly true in the October 2007 –
March 2009 bear market, when the fortresslike
balance sheets of such firms became highly prized amid
the financial crisis. Over that period, Vanguard
Dividend Appreciation Index VDAIX (which tracks
the Nasdaq US Dividend Achievers Select Index
that is composed of companies that increased their
payouts over each of the previous 10 years) lost
46.3%, but that was substantially better than the 54.9%
decline of the S &P 500.
But the recent closing of Vanguard Dividend Growth
VDIGX has us wondering whether dividend-growth
stocks have peaked. Higher-quality firms have had a
strong run in both absolute and relative terms in
recent years. Thus, at the end of July 2016, the Nasdaq
US Dividend Achievers Select Index traded at a higher
price/earnings ratio (23.5) than at any previous point
since data became available in June 2006—much
more richly priced than it was at its September 2008
trough, when the P/E was 11.4. Meanwhile, the S& P
500 Dividend Aristocrats Index, which has similar char-
acteristics (it tracks companies that have increased
their dividends for 25 consecutive years) recently traded
at its highest P/E ratio since May 2003. That index’s
P/E fell to 10 .1 in early 2008 and recently matched the
Dividend Achievers’ 23.5.
At the same time,the balance sheets of the companies
in both indexes have become more leveraged in order
to take advantage of historically low interest rates—
the debt/capital ratios of both indexes recently peaked
and stood far above their levels of a decade ago.
Given the companies’ increased price risk and debt,
it’s quite possible that they may not hold up as well in
the next market downturn. They still possess some
relatively defensive characteristics due to the strength
of market positions and relatively strong balance
sheets, so it’s unlikely they’ll lose a lot more than the
broad market in such a scenario, but they may
merely perform in line with it. Let’s take a closer look
at a few of the most prominent quality-focused funds.
Vanguard Dividend Appreciation Index
As mentioned above, this large-blend fund, which has
a Morningstar Analyst Rating of Gold and launched in
2006, tracks the Nasdaq US Dividend Achievers Select
Index. The focus is thus on dividend growth, rather
than high yields—the fund’s trailing 12-month yield
has typically been around 2%. While its overall Morn-
ingstar Risk rating is Low, that may rise given its port-
folio’s current elevated valuations and debt levels.
Jensen Quality Growth JENSX
While dividend growth isn’t an emphasis at this Silver-
rated large-growth fund, the managers also pursue
companies with sustainable growth characteristics—
they limit their search to those companies that have
generated a return on equity of at least 15% in each of
the previous 10 years. As a result, this fund, like the
Vanguard offering, invests heavily in companies with
wide Morningstar Economic Moat Ratings (a measure
of long-term competitive advantages). Its average P/E
ratio is at a 14-year peak, and its most recent debt/
capital ratio is the highest it’s been since Morningstar
began collecting that data in late 1999. The fund
has typically held up very well in down markets—it lost
less than the Vanguard fund in the last bear market.
But here again, increasing valuations and debt could
make it less buoyant next time.
Dreyfus Appreciation DGAGX
This Bronze-rated large-blend fund hasn’t performed
as well as the above funds, in part because of above-
average stakes in energy stocks (which were
hammered in 2014 and 2015) and non-U.S. stocks. But
management does place a heavy emphasis on
dominant firms, as reflected in the portfolio’s moat
ratings. And the metrics have followed a similar
pattern—the P/E ratio is at its highest level since
early 2002, and the debt/capital ratio is at a peak. K
Contact Greg Carlson at
Price Risk Is Growing for
Dividend Growth
Red Flags | Greg Carlson
What is Red Flags?
Red Flags is designed to alert
you to funds’ hidden risks. Such
risks can take many forms,
including asset bloat, the
departure of a solid manager, or
a focus on an overhyped asset
class. Not every fund featured
in Red Flags is a sell, and in fact,
some are good long-term
holdings. But investors should
be prepared for a potentially
bumpier ride in the near future.