CDL: Investment Process Produces A Mixed Bag Of Good And Bad Holdings

Editor’s note: Seeking Alpha is proud to welcome The Value Hunter as a new contributor. It’s easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Premium. Click here to find out more »

VictoryShares US Large Cap High Div Volatility Wtd ETF (NASDAQ:CDL) seeks to offer income investors a rules-based ETF that bridges the gap between active and passive management. The CDL strategy is twofold: it combines fundamental criteria with a unique volatility weighting methodology that offers a risk-adjusted weighted dividend approach to large-cap stocks. While the investment approach is intriguing, we think their process results in bets on both good and bad sectors — thus the mixed bag analogy — and likely so-so returns in 2024.

CDL Investment Rule 1: Fundamental Criteria

The CDL management team (in place since July 2015) culls through its large-cap equity universe of dividend payers who have produced positive earnings over the last 12 months. That’s it! No look to the dividend coverage ratio, which is often considered an indicator of dividend stability. Nor does the team consider earnings or dividend growth forecasts, which are often additional fundamental indicators of corporate strength and hence dividend safety. Again, profitability for the past 12 months is the sole factor when selecting stocks from the index CDL tracks — the Nasdaq Victory US Large Cap High Dividend 100 Volatility Weighted Index. (Examples of companies held as of mid-January include: Coca-Cola (KO), Kraft Heinz (KHC), PPL (PPL), Duke Energy (DUK), Goldman Sachs (GS) and Citigroup (C).)

CDL Investment Rule 2: Volatility Weighting Vs Market Cap Weighting

The most recognized market-cap weighted index in the US is typically the S&P 500 Index. The S&P 500 seeks to be a proxy for the broader US stock market, constituting the largest 500 publicly traded companies in the US. Indeed, it represents approximately 80% of the equity market. However, because this is a market-cap weighted index, a few large companies can drive an outsized performance of the overall index. Last year’s Magnificent 7 (Apple (AAPL), Alphabet (GOOGL), Microsoft (MSFT), Amazon (AMZN), Meta Platforms (META), Tesla (TSLA), Nvidia (NVDA)) is a case in point. While the Mag 7 average 2023 performance was 111%, many other index sectors struggled to return 24% or less.

Volatility-weighting is an alternative approach to market-cap weighting, when constructing a portfolio. Put simply, this allows investing in equities with a priority to risk control, as defined by a company’s stock price volatility. CDL begins with the 100 highest dividend-yielding stocks within the Nasdaq Victory US Large Cap 500 Volatility Weighted Index. (if interested, see the Nasdaq produced “Risk Reduction Using Volatility-Weighting”). After CDL screens for the 12-month profitability of these 100 highest dividend-yielding stocks, the stocks are weighted by their volatility metric: the standard deviation over the last 180 trading days. In contrast to most ETFs that reconstitute annually, CDL reconstitutes twice a year to reflect its holdings performance based on the last 6 months of trading data. We believe this keeps CDL perpetually backward-looking rather than anticipating future sector or market moves.

A Sector Concentration That Implies A Mixed Bag Of Potential Performance

CDL has high concentrations in the utility (24%), financial (21%), consumer staple (16%) and energy (12%) sectors. While these sectors are widely known as dividend payers, this kind of concentration is why we believe CDL’s potential 2024 returns are a mixed bag.

On the one hand, there are potential tailwinds for utilities that will begin in earnest in 2024 and continue for decades for two reasons: potential rate cuts at the Fed and the decades-long tax incentives offered to utilities (and mid-stream energy operators) through the 2022 Inflation Reduction Act (IRA).

Utilities are often considered bond proxies by many investors, given the high correlation between Treasury yields and the dividend yield of regulated utilities. However, utility valuations are based on their earnings and dividend growth, along with the ability to recover expenses in a monopoly service area. Hence, utilities’ total return is a combination of price appreciation through earnings as well as dividend growth. At the same time, utilities are highly sensitive to interest rates, given their intense capital investments. In a potential climate of lowering interest rates, and decades of IRA incentives to build out the electric grid, pipelines, and green energy conversion, we believe utilities are in a sweet spot for price multiple expansion. In contrast, Treasuries have coupons that remain fixed with total returns that can fluctuate based on whether the Treasury is held to maturity.

On the other hand, CDL’s second-largest sector, financials, will likely face continued headwinds in 2024. Fear of the lagging impact of intense interest rate increases is widely discussed. Less well known is the fact financials are subject to expanding regulatory controls through the implementation of Basel III measures believed to go into effect 2025 in phases through 2028. US Banking CEOs have been widely critical as increased capital requirements would significantly impact their cost of capital and raise banking costs for many Americans.

Comparison To Other Dividend Paying ETFs

In the charts below, we compare CDL with three other ETFs in our universe: Franklin U.S. Low Volatility High Dividend Index ETF (LVHD), T. Rowe Price Dividend Growth ETF (TDVG), and SPDR Portfolio S&P 500 High Dividend ETF (SPYD). CDL and LVHD are both low-volatility and high-dividend ETF plays, with almost identical risk (SD of 15%, per SA) and current yield (3.6%, per SA) profiles. In contrast, looking at TDVG shows the difference in performance a dividend growth-focused ETF (SD 13% and 1.3% yield) can add to a portfolio. Growing dividends is typically a sign of a healthy company. Finally, SPYD (SD of 21% and a 4.7% yield) highlights what a straight yield-oriented ETF can offer, without consideration to dividend payout quality, hence the much higher standard deviation.

While past performance is not indicative of future performance, note the 1-year and 3-year total returns of these ETFs. Their sensitivity to the Fed’s interest rate hikes, perceived or realized, can be seen in these charts. The Fed began its latest interest rate hiking cycle in March 2022 and continued through July 2023. Note the volatility in total return for these interest rate-sensitive ETFs during this time frame. Also evident, is the upward pivot beginning in October 2023 when the broader market perception began to favor the Fed halting increases.

When we apply valuation metrics to CDL’s price, we conclude, for now, that this ETF is fully valued. We would not add to any position at this time. The forecasted P/E ratio of 14.4 (per YCharts) is slightly below CDL’s trailing P/E of 14.8. WE would want to see a discount of at least 10% before we would consider initiating a new position or adding to any current holding of this ETF. CDL has a decent projected dividend growth rate of 9%, but pales when compared to TDVG’s stellar 28% growth rate.

Final Conclusions

Given CDL’s rather simplistic investment thesis of applying backward-looking rules-based selection metrics, we would not recommend purchasing this ETF currently. While the high concentration in utilities could provide tailwinds for potential P/E multiple expansion, we believe this will be tempered by the similarly weighted financial sector’s uncertain prognosis.

In sum, there are more downside risks to CDL than upside potential. Should interest rates change in either direction or a more bank-positive outcome of Basel III regulations emerge, we will reevaluate our recommendation.