SDVY: Low Yield, Low Expectations For These Small/Mid-Cap Rising Dividend Achievers

Investment Thesis

I last reviewed the First Trust SMID Cap Rising Dividend Achievers ETF (NASDAQ:SDVY) on March 28, 2024, assigning it a "sell" rating based on its constituents' low expected dividend and earnings per share growth. Since that article was published, SDVY delivered a 3.86% total return, which was around the same as peers like the WisdomTree U.S. MidCap Dividend Fund ETF (DON) and the ProShares S&P MidCap 400 Dividend Aristocrats ETF (REGL).

The iShares S&P Small-Cap 600 Value ETF (IJS) and the iShares S&P Mid-Cap 400 Value ETF (IJJ) did slightly better, but the main concern was SDVY's $0.1503 per share June dividend payment, which was 28% less than the June 2023 distribution. The Q1 payment was also lower, and as a small/mid-cap fund designed for DGI investors, this trend is alarming. Therefore, my goal with this article is to provide an update on SDVY's fundamentals compared to the four ETFs listed above and assess whether this lower dividend trend is an anomaly or if shareholders can expect a return to dividend growth moving forward. I hope you enjoy the read.

SDVY Overview

Strategy Discussion

SDVY tracks the Nasdaq US SMID Cap Rising Dividend Achievers Index, selecting small and mid-cap stocks based on fundamental metrics like earnings, dividends, debt, and dividend payout ratios. The Index applies some basic size and liquidity screens ($500 million minimum market cap, $2 million average daily trading value) and excludes REITs, meaning all dividends should be considered qualified income for tax purposes. I've listed some other screening criteria below:

1. Securities must have a one-year trailing dividend greater than their trailing three- and five-year dividend rate.

2. Securities must have positive one-year earnings per share and greater than its earnings per share three years ago.

3. Securities must have cash-to-debt ratios above 25% and a dividend payout ratio of less than 65%.

Eligible securities are ranked by the dollar increase in their dividends over the previous five years, their current dividend yield, and their current dividend payout ratio. Based on these rankings, 100 securities form the Index, with 75 selected from the NASDAQ US Mid Cap Index and 25 chosen from the NASDAQ US Small Cap Index. Lastly, the Index limits the number of stocks to 30 per sector, equal-weights its members, rebalances quarterly, and reconstitutes annually in March.

I criticized several of these screens in March. Essentially, they only ensure non-negative earnings and dividend growth over 1-5 year periods, which is not nearly sufficient to deliver the high-single-digit dividend growth rates investors can get with less volatile and cheaper large-cap dividend funds. Furthermore, I question the rationale of management teams that elect to increase dividends at a high rate even when earnings per share growth was negative last year. That was the case for 55% of SDVY's holdings in March, and remains true now.

A common solution is to screen for consistent annual dividend growth, such as the Dividend Achievers or Dividend Aristocrats methods employed by ETFs like PFM and NOBL. While this doesn't take care of the earnings growth problem, SDVY's Index only evaluates a company's earnings against their earnings three years ago. Thinking forward to 2025, that will be a pretty easy target to hit, given how most company's earnings for the base year (2022) were low.

SDVY Performance

Compared to its peers, SDVY has delivered a solid 10.25% annualized return since December 2017, beating out DON, REGL, and IJJ by 1-2% per year. The downside was higher volatility, as measured by its 23.59% annualized standard deviation figure. However, its downside risk-adjusted returns (Sortino Ratio) were still relatively strong, rivaled only by REGL. REGL has one of the lowest five-year betas of any small/mid-cap fund, mainly due to the 22% allocated to Utilities, so this is not surprising.

While SDVY's long-term results were good, most was attributed to its 28.55% gain in 2023, which was about twice as good as DON and IJJ's and 23% better than REGL's. Without that year, SDVY's average annual return between 2018-2022 was actually lower than REGL and IJJ's. I point this out because it's unlikely anyone relying on past performance would have selected SDVY in January 2023, and these "performance chasers" probably aren't too thrilled with the returns and dividend growth thus far in 2024.

SDVY Analysis

Sector Allocations and Top Ten Holdings

The following table highlights the sector allocation differences between SDVY, DON, REGL, IJS, and IJR. SDVY is the least diversified of the five, with 76.31% allocated to only three sectors (Financials, Industrials, and Consumer Discretionary). It's not uncommon for "themed" ETFs to be poorly diversified, but broad-based funds like IJS and IJJ also demonstrate how Financials dominate the small/mid-cap value segments.

Specific to SDVY, Regional Banks comprise 15.61% of the portfolio, compared to 7.80% and 11.97% for DON and REGL, respectively. Historically, this industry has not been good from either a return or risk perspective. For example, the iShares U.S. Regional Banks ETF (IAT) underperformed IJJ most years between 2006 and 2024, often substantially. For this reason, I'm not thrilled about overweighting it.

SDVY's top ten holdings are next, totaling about 23% of the portfolio. Securities are equal-weighted, so each stock receives roughly a 1% weight at each rebalancing. The top holdings you see below, which include Eastern Bankshares (EBC) and Mueller Industries (MLI), are only at the top of the list because of their strong recent performance. They currently trade near their 52-week high prices.

SDVY Fundamentals By Sub-Industry

The following table highlights selected fundamental metrics for SDVY's top 25 sub-industries, which total 78.85%. By comparison, DON is better-diversified, with 63.02% of assets in its top 25 sub-industries. REGL's concentration is worse at 90.74%, while IJS and IJR are in the 50-55% range and are better broad-based options.

As promised, I will examine SDVY's dividend features shortly, but first, here are four takeaways to consider:

1. In the performance analysis earlier, we saw how SDVY lagged in market down years like 2018 and 2022, and its current 1.24 five-year beta indicates investors can expect that again should markets decline soon. Notably, several third-party websites list SDVY's five-year beta at around 1.05, which suggests it's not much more volatile than market funds. However, these calculations are based on the ETF's prior price movements and do not account for the substantial portfolio turnover rates rules-based funds tend to have. SDVY's portfolio turnover rate averaged 67% from 2019-2023, so it doesn't make much sense to analyze an ETF with the statistics of holdings it no longer includes. Please note this also limits the helpfulness of technical analysis.

2. SDVY's Index yield is 2.45%, but after deducting the fund's 0.60% expense ratio, shareholders only net 1.85% at current prices. The yield is almost identical to IJJ's (1.99% Index, 1.81% net), and DON and REGL feature much better starting yields.

3. There is a substantial disconnect between SDVY's constituents' annualized three-year sales and earnings per share growth rates (7.74% and 6.57%) and its annualized three-year dividend growth rate (16.92%). Scanning the list, the biggest offenders are in the Regional Banks, Industrial Machinery & Supplies, and Oil & Gas E&P sub-industries. These metrics are essential because expecting strong dividend growth without adequate earnings growth is unrealistic.

In addition, I remain concerned with the disconnect between the three-year earnings per share growth rate (6.57%) and the one-year earnings per share growth rate (-6.96%). We can reverse-calculate a 14.06% average growth rate for the first two years, which means earnings declined by 21% in the last year alone. Notably, this decline was the largest in the peer group, with REGL and IJS holding up the best, as follows:

• SDVY: 14.06% / -6.96% (-21.01%)
• DON: 9.73% / -3.62% (-13.34%)
• REGL: 4.60% / 1.72% (-2.88%)
• IJS: -3.30% / -2.70% (+0.60%)
• IJJ: 5.12% / -2.68% (-7.79%)

SDVY's holdings may be called "rising dividend achievers", but these statistics imply they're better classified as "fallen angels".

4. SDVY trades at 12.30x forward earnings and 7.76x trailing cash flow, making it one of the cheapest dividend funds on the market. While low valuation ratios are common for funds with high allocations to stocks in the Financials sector, SDVY also has a relatively good 5.64/10 sector-adjusted value score, which I derived from Seeking Alpha Factor Grades. DON and REGL's scores are 4.96/10 and 4.66/10, while IJS and IJJ score 5.45/10 and 4.97/10, respectively.

SDVY Dividends: A Closer Look

SDVY received a "C+" Dividend Grade from Seeking Alpha's ETF Grading System, mainly because its 1.49% trailing dividend yield and -24.13% one-year dividend growth rate figures are well below the median for all ETFs. If it weren't for the fund's high 0.60% expense ratio, the yield would be more competitive, but that's the "First Trust" way. I track 70 First Trust ETFs, and the expense ratios range from 0.45% to 0.96% and average 0.62%. As a result, dividend yields will always be much lower than the yields of the underlying constituents, and I rarely suggest them to income investors.

SDVY's three- and five-year dividend growth rates are much better, at 19.63% and 8.78%, respectively. The ETF is on a two-year dividend growth streak, but that could end soon. As shown below, the first two quarterly dividend payments this year were below the March and June 2023 payments.

The good news is that the September 2023 payment of $0.0982 per share was quite low and should be easy to beat in Q3. With a 1.85% expected yield and a current price of $36.00 per share, the annual distribution is $0.666, or $0.1665 per quarter. If that holds, that will bring 2024's total distributions to $0.5865, below the $0.6225 total from 2023.

Of course, these are estimates only and don't account for fluctuating share prices, rebalancings, or changes in outstanding shares just prior to ex-dividend dates, which dilute dividend payments. Nevertheless, if you are a current shareholder and were disappointed by the Q2 payment, my advice is not to get too discouraged. The Q3 and Q4 payments should be better, just not high enough to keep the annual dividend growth streak alive.

Investment Recommendation

I have several concerns with SDVY. First, its 0.60% expense ratio works against the interests of income investors and reduces the yield from 2.45% to only 1.85%, which is pretty much the same as IJJ. Second, SDVY's current holdings have grown dividends far above earnings over the last three years, and analysts expect only 0.43% earnings growth next year. Third, dividend growth could be negative in 2024, which is contrary to one of the fund's primary investment objectives. And fourth, it's quite volatile with a high allocation to Regional Banks, which typically underperform in most environments. On the plus side, SDVY's value features are excellent, but I think that's the only reason to buy it right now, and it's not enough to warrant changing my "sell" rating. Thank you for reading, and I look forward to answering your questions in the comments below.