SCHD: Not Fearful Of A Recession

Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD) has outperformed the S&P 500 (SPY) (SPX) at the recent pullback after Fed Chair Jerome Powell and his FOMC surprised investors with their hawkish stance through 2023.

Coupled with SCHD’s robust 3.39% dividend yield (vs. SPY’s 1.65%), it has provided dividend investors with less volatility in their portfolio’s total return over the past year.

Accordingly, SCHD posted a 2022 total return of -3.2%, well above the SPY’s -18.2% decline. It has also beaten the SPY over the 5Y to 10Y horizon, underscoring the benefit of investing in stable, mature companies.

You wouldn’t find so-called unprofitable “disruptive tech” companies such as those in Ark Invest’s flagship ARK Innovation ETF (ARKK), which has round-tripped nearly three years of gains. As such, investors who invested at its 2021 highs have seen tremendous wealth destruction.

However, SCHD’s focus on companies that have proven their dividend record, such as requiring ten consecutive years of dividend payouts, shouldn’t be understated. With a 5Y dividend growth CAGR of 13.7%, SCHD has demonstrated to investors that investing in stable companies with a “growth and value” blend has been highly beneficial for wealth accumulation.

SCHD has a higher financial sector focus, with a 20.6% weighting. Financial stocks performed well in 2022, as the sector recovered remarkably from its October lows before the recent pullback.

Two of SCHD’s leading financial holdings, The Allstate Corporation (ALL) and Prudential Financial (PRU), have also posted solid performances. Accordingly, ALL has nearly recovered its October highs, while PRU exceeded its August highs before its recent pullback. We highlighted in a September Prudential article discussing why PRU likely bottomed.

SCHD also has a strong tech focus with a weighting of about 16%. While it has fallen down the pecking order slotting in as its third largest sector in the ETF currently, it occupied the top spot as recently as its end-September update.

Given the underperformance of tech over the past few months, as the sector remains well below its August highs, investors should be assured of having Broadcom (AVGO) as its top holding. Broadcom is a highly profitable and well-diversified semiconductor company that largely avoided the malaise in consumer electronics, given its enterprise/hyperscaler focus.

Coupled with CEO Hock Tan’s commitment to driving free cash flow profitability and consistent dividend payouts, the market has also rewarded AVGO investors well despite the semi downturn. Accordingly, AVGO’s 2022 total return of -13.2% significantly outperformed its semi peers represented in the iShares Semiconductor ETF (SOXX), which posted a 2022 total return of -35.1%.

Moving forward, with SCHD having outperformed the SPY from its October lows, investors may need to temper their expectations of continued outperformance from here.

Even though the Fed is expected to remain hawkish through 2023 (median Fed funds rate of 5.1% by the end of 2023), interest rate strategists expect the Fed to pivot earlier than expected, as we could potentially move into a recession.

Some investors could argue that SCHD’s defensive positioning should help shield it better in a deep recession. However, if our thesis of a mild-to-moderate recession plays out in 2023, we postulate that it has already been contemplated at the S&P 500’s lows in October.

Could financials and industrials stocks that have outperformed recently lag behind their tech peers if the Fed pivots earlier? Given the battering that the more tech-focused SPY was hit in 2022, an earlier pivot could potentially lift tech’s recovery, as the SPY’s PE remains below its 10Y average. In contrast, the P/E of SCHD’s top holdings has normalized after its sharp recovery.

However, if we fall into a deeper recession than anticipated, SCHD’s less tech-exposed positioning and more robust dividend yield could help shield it against downside volatility better.

Hence, we believe SCHD could still play a critical role in investors’ portfolios as a core or supplementary holding, whether they are growth or value investors.

For now, we encourage investors to await a deeper pullback to improve their reward/risk profile before adding more positions.

Rating: Hold (reiterated).