(PUB) Investing 2016

11

September 2016

Morningstar FundInvestor

Price Risk Is Growing for Dividend Growth Red Flags | Greg Carlson

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 greg.carlson@morningstar.com

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

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.