SCHD ETF: Defensive With A Nice Yield But Investors Need To Be Selective

What is SCHD

The Schwab Strategic Trust – Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD) is an ETF that focuses on investing in high-dividend-yielding stocks in the U.S. with a record of consistently paying dividends, selected for fundamental strength relative to their peers, based on financial ratios. The ETF is designed to track the total return of the Dow Jones U.S. Dividend 100™ Index.

SCHD has an expense ratio of 0.060% and a 30 day SEC yield of 3.41%. This expense ratio is lower than the 0.0945% expense ratio of SPY, and the dividend yield is over double the SPY’s 1.61% yield.

Performance and Holdings

Over the past year SCHD has beaten the SPY by 12.94%, which is a sizeable outperformance.

SCHD has also beaten SPY over a five-year timeframe, which doesn’t seem intuitive given the blue chip nature of the holdings and how strongly growth stocks performed over that time period. If I had to blindly guess I would assume that SPY had performed better because it has more exposure to growth, but the fact that SCHD has done so well is a good lesson in how sometimes the most boring and straightforward investments can perform the best.

Let’s take a closer look at the top 20 holdings in the ETF and some of their fundamental valuation ratios.

The ETF holds a lot of blue-chip companies that pay a high dividend yield. Most of these companies are easily recognizable and are stable businesses. Their consistent nature is the main benefit of buying the ETF. The mix of a decent yield and diversified holdings with defensive characteristics makes SCHD a good ETF for investors concerned about the current economic environment. These companies are able to weather the economic storm which is why the ETF has outperformed the broader market in 2022. People will continue to buy soda and pharmaceuticals and use their phone service no matter what the economy does. While these companies may not grow very much, their consistency makes them sort of like a bond with upside. Investors get the yield and the added potential for the businesses to grow.

Due to the nature of established dividend growing companies the most important ratio I would highlight is the long-term debt to earnings ratio. This measures how many years it would take a company to pay off their long-term debt with their current earnings. For many of these companies it would take them 2 years or less to pay off this debt, which is pretty good. On the flip side, there are some companies that seem to have too much debt.

Debt loads are important to consider because too large of a debt load will impede the long-term dividend growth potential. These companies may run into difficulties down the road which could lead to a dividend cut or suspension. A high debt load also reduces the flexibility of the business, which increases risk for investors.

Some companies that would take over 5 years to pay off their debt using current earnings such as Verizon Communications (VZ), International Business Machines (IBM), Amgen (AMGN), and Altria Group (MO) might warrant being avoided by investors. (US Bancorp is a special case because of how banks operate, so their book debt isn’t much of a concern). These companies may look cheap when looking at traditional metrics such as PE and P/B, but these metrics mask their massive debt loads which are a financial burden and significantly hinder the long-term prospects of the business, especially if this debt needs to be refinanced at a higher rate.

Verizon, IBM, and Altria all have high dividend yields but these yields are probably not safe in the long run, especially in the case of Altria. Their business has insurmountable secular headwinds and is vilified by people and governments around the world. This combined with a large debt load is a recipe for a dividend cut or suspension.

If investors are interested in SCHD but want to avoid some of the stocks in it, they can look at the ETF’s holdings and selectively buy companies they like while avoiding businesses that may be problematic because of a high debt load or because the investor is bearish on the prospects for that company. If investors would rather buy the stocks than buy SCHD outright, the company I would absolutely avoid investing in is Altria. The rest of them all have their strengths and weaknesses, so it comes down to how an investor personally feels about the prospects for each business.

Conclusion

Dividend investors that are concerned about the current macro environment may want to consider buying SCHD at these levels. The defensive nature of the holdings means that the ETF has held up well in 2022, but if economic conditions improve SCHD will likely lag SPY. That being said, investors can’t really go wrong holding this ETF long-term and it’s a good addition to a diversified portfolio.