Normally when you do one of these Monday morning posts, you wind up recapping the prior week and trying to find some tidbits of useful information to parlay into a story about how the market is shifting direction. Some Monday morning quarterbacks will point out the improving economic outlook from the Employment report and the big hits to utilities and consumer staples and say the economy is right back on track. Global macro managers will say that it doesn’t matter what happens in one report, the global economy is shot and the Fed will never hike again. Zero Hedge will say nothing ever matters because the market is rigged by the global elite in blah blah blah.
From my point of view, and at risk of sounding like a dog with a bone, I think one of the major events of the week was the announcement by Vanguard that they were closing their Dividend Growth Fund (VDIGX) to new investors after taking in more than $4 billion in new assets so far in 2016. Having seen my fair share of funds blow up after taking on way too much new money (looking at you Marketfield) I have to be honest and say that I respect any manager who’s willing to say stop, but I think the market was too quick to dismiss this as a Vanguard or a fund-specific issue. But the closing of Vanguard Dividend Growth is way more important to understanding the state of the market than simply saying the dividend income theme is played out.
The first thing any commentator, especially yours truly, is that the classic defensive sectors are way overbought. Check out my quick and dirty charts showing the relative momentum of the Utilities Sector Select SPDR (XLU) and SPDR S&P Bank ETF (KBE) for an example.
(click to embiggen)
But consider where the fund chooses to invest, typically in large-cap to giant-cap names with ample liquidity and extensive analyst coverage with the smallest company in the portfolio having a market-cap of over $25 billion and yes, it does have a larger allocation to consumer staples but no utilities and hardly any REIT exposure and with just 45 names, no one can accuse the manager of letting his alpha leak away through excessive diversification. So this fund has little in common with the stronger performing ETF’s we talked about last week.
So even with $30 billion in AUM, VDIGX invested in the largest of large-cap names and with a fairly broad universe to choose from so why close the fund? Let’s start with the “Buffet Dilemma” where you have literally so much money to manage that it’s almost impossible to do it properly. You can’t accumulate small positions and build them-up over time because you have, bear with me, ALL the money in the market. Your buys and sells will have a major market impact that won’t go unnoticed and opening your up to all sorts of issues although probably nothing like what Good Harbor used to face back in it’s heyday. Now there’s a problem they wish they still had. In Buffet’s early years it wasn’t uncommon for him to invest large portions of his various partnerships in just one stock, like American Express, giving him the chance to strongly outperform. Now he has to buy whole companies.
Even more important than how you buy is what you buy so the real question is just what exactly can you find today that still meets your investment criteria? If your focus is on quality companies, typically with market caps above $25 billion, paying sustainable dividends, well good luck with that! More than 75% of the broader NYSE is now trading above its 50 and 200 day moving averages while the latest Factset earnings insight report shows that forward P/E multiple has actually risen since the start of earnings season as the market has taken off faster than earnings expectations!
But for most people, those are just dry statistics so here are two quick and intuitive ways to consider how expensive U.S. equities have gotten using VDIGX’s portfolio as example.
Current Portfolio: According to Morningstar, the fund is trading at multiples that are at a premium to the broader Russell 1000 while the TTM dividend yield is now just 1.83%, barely 50% of the AAA bond yield. That’s actually BELOW the yield of the Russell 1000. In other words, high quality dividend payers are now so sought after they’re trading at a premium to the rest of the index.
Future Buys: So why not sell expensive names for cheap ones? Because there’s nothing left for a fund like VDIGX to buy. I reran my Finviz screen looking for stocks with yields above the AAA bond yield and with an earnings yield 2X that and then cut away REITS (20 names), LP’s and royalty trusts (36 names) then anyone with a dividend payout ratio about 70%. If you want liquidity and look at trade volumes above 200K a day, you get just under 50 names…on the 21st it was more like 55 and even that is an exaggeration since finviz will only let me screen for yields above 3% and P/E’s below 15.
That may not seem like such a big swing but remember, we’re talking about the companies that have more or less been hit hard in 2016 and left for dead, not the sort of names that make up VDIGX. According to Morningstar, the manager typically buys names with a wide moat and in excellent financial condition. My list…. not so much so. If I was to rerun my screen and exclude highly levered companies or those with a lower current ratio, I’d be hard-pressed to even get 40 names for a fund and remember than my universe is all domestic stocks, not just those that make up the Russell 1000. Tightening up the yield and P/E ratios so they’re in line with the AAA bond rules would cut that list down even more, well below the 45 names in this fund or the 50 we typically saw in different dividend income ETF’s.
In other words, if I was starting a fund today I could either invest for dividend yields or sustainable dividends, but not both without having to seriously compromise the portfolio by having only a handful of names/ There were just 13 companies with a market cap of $24 billion or greater and only one of which, Wells Fargo, is currently in VDIGX which should say something about the financial or market conditions facing the other 12 larger names in my list and with market conditions like this, it becomes a lot easier to understand why Vanguard decided to close VDIGX for new investors. Unfortunately, these problems aren’t specific to VDIGX.
First there’s the obvious problem of herding; mutual fund strategies focusing on high dividend yields have a lot in common with their ETF counterparts. Mutual fund managers have more leeway when it comes in how to employ their screens and select names, but they utilize the same basic philosophy when it comes to HOW to screen and review different stocks, hence the emphasis on herding. Let’s say I’m right and the manager of VDIGX closed because his fund was too big and there aren’t enough opportunities out there to put that capital to work, will other managers follow his lead? Vanguard has a strong reputation but 2016 has been a challenging year for many fund families and I’m willing to wager that if you have an “equity income” strategy that’s been pulling in new capital, there’s going to be tremendous pressure both on wholesalers to keep selling the fund and on managers to make sure it doesn’t close no matter what. And how do you make that happen?
Style drift would be the obvious place to start, I expect that managers who traditionally only bought large-cap stocks will find themselves considering more mid-cap names, mid-cap managers will look at small-caps, etc etc. Managers with a broader universe like the Russell 3000 will do it without too much consideration but it’ll be interesting to find managers with a more well-defined responsibility, like keeping tracking error relative to the Russell 1000 fairly small, drifting further from their benchmark. I never put much faith in active share but it’ll be interesting to compare changes in tracking error going forward to see who shifts their strategy to suit their bosses rather than sticking with their original strategy.
Vertical style drifting from larger to smaller stocks is one thing, perhaps even more insidious would be managers who decide to go horizontal as well and go from blend to deep value. The strength of VDIGX was its focus on buying high quality names with strong balance sheets, not buying uber-cheap names hoping that mean reversion (or investor desperation) kicks in. It’s like comparing Buffet’s focus on growth at a reasonable price to his mentor’s focus on “cigar butts” or discarded items with a few puffs of free smoke left in them. Some managers will doubtless stand by their convictions and say that if the markets yield is low, there’s no point in chasing cheap stocks looking for higher yielding names, but others could feel the pressure from overzealous sales teams to get the headline yield higher to attract new capital.
So why does this matter? Because the impact of style drift can be felt almost immediately if the market shifts in the wrong direction but the literature and track record being attached to the fund will be backward looking. Imagine in VDIGX suddenly shifted to the Yinzer Analyst’s deep value approach; the track record being presented would be for a GARP strategy but the future performance will be for something entirely different! If the market continues higher and investors keep rummaging for yields like hogs after truffles, no problems but it could just as easily (and eventually will) go the other direction.
Ultimately this all means that not only is the broader market so expensive that dividend income managers can’t find good opportunities but that conditions in the industry are such that there will be a tremendous amount of pressure to keep funds open even if it means style drift by a large swath of managers in the space. The fourth and final part of my focus on dividends by finding strong managers in the space (who are still open) will zero in on those who have both a great track record and who aren’t likely to change their style to suit their bosses.