QDEF – QDEF: Volatility-Averse Dividend Play With Issues Beneath The Surface
FlexShares Quality Dividend Defensive Index Fund (NYSEARCA:QDEF) has an alluring strategy at first blush, with a sophisticated methodology designed to pick U.S. dividend stocks with robust quality, while also not ignoring volatility, something safety-oriented investors should appreciate. QDEF has a moderate expense ratio of 37 bps, with $322.1 million in AUM amassed since its inception in December 2012.
I believe among my dear readers, there are investors who are mulling gaining exposure to defensive dividend mixes rich with top-quality stories to prepare for a potential recession, so QDEF might look close to ideal for them. Unfortunately, the ETF has a few issues beneath the surface.
First and foremost, its valuation is rather inflated. Also, Apple (AAPL) and Microsoft’s (MSFT) heavy equity mix (the combined weight of ~13.9% as of May 26) does not look that defensive, unless an investor considers both names having consumer staples- or utilities-like characteristics (a thesis could be constructed here, but I believe it would be rather speculative). Next, it has a measly exposure to the growth factor. Besides, its performance is fairly unconvincing, despite a few years after its launch and 2022 being bright spots. Its low dividend yield and patchy growth in distributions also weigh on the rating, precisely like in the case of the FlexShares Quality Dividend Index Fund (QDF) which I covered a few weeks ago. In sum, QDEF earns only a Hold rating from me, which could be potentially revised higher in the future in case valuation improves.
What is at the crux of QDEF’s strategy?
According to the QDEF website,
The Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the Northern Trust Quality Dividend Defensive Index (Underlying Index).
Overall, I would say its methodology is mostly similar to the one used by the Northern Trust Quality Dividend Index (which is the basis of QDF’s strategy), with the exception being “a targeted overall beta that is generally between 0.5 to 1.0 times that of the Northern Trust 1250 Index (the “Parent Index”),” as described in the prospectus.
During the selection process, eligible securities face a quality test incorporating such “core components” as management efficiency, profitability, and cash flow. Those that do not pay a dividend are removed. The optimization process is designed to boost the quality exposure, dividend yield, and “achieve the desired beta target.” The index is rebalanced on a quarterly basis. For more details on the process, reading the prospectus should be considered.
Key valuation considerations. The high earnings yield mystery and what is behind it
I strongly believe that defensive strategies (including those using volatility screens) should be mindful of value. So the question worth asking here is whether QDEF’s mix is priced adequately. At first glance, it is, as my calculations show the weighted-average earnings yield of this 118 strong IT-heavy basket at almost 5.8%, which is fairly high for a fund investing in defensive quality stories and having a WA market cap of about $527.5 billion as per my analysis (as of May 28). The problem here is that 1) the yield is skewed by two contributors, 3) the debt-adjusted yield points quite to the contrary, 2) value exposure measured by the Quant indicators tells an entirely different story.
Let us start with the fact that the EY is skewed. QDEF has exposure to two names with abnormally high LTM net earnings that either exceed their market caps or are equal to a meaningful share of them. ZIM Integrated Shipping Services (ZIM) is the first name on this list, and Chesapeake Energy (CHK) is the second.
With their yields in a theoretical model reduced to the medians for the industrials and energy sectors (5.4% and 14.3%, respectively), QDEF’s weighted average goes straight to around 5%, which is, anyway, still higher than the yield of the S&P 500 index by almost 40 bps.
Nevertheless, the EV/EBITDA perspective is different, as an 18.8x ratio is clearly inflated. Do an 18.8x ratio and a 4.4% forward EBITDA growth rate chime well? I doubt that. Importantly, please take notice that the figure excludes certain financial sector stocks.
Next, the Quant perspective is the least supportive of a value thesis here. With almost 75% of the holdings having a D+ Valuation grade and worse, I doubt this equity mix has a sufficient margin of safety, if at all. Answering the question of what contributed to that result, I should note that most relatively overvalued plays in this mix are from the IT and healthcare sectors; at the same time, there are no overvalued materials stocks. The chart below adds some context.
What is especially worrisome here is that QDEF’s weak valuation characteristics come with a critically small exposure to the growth factor. My calculations show QDEF’s weighted-average forward revenue growth rate is at 4.7%, while EPS should grow at only 4.8%.
Are QDEF dividend holdings truly defensive? At least, their quality is impeccable
QDEF does not compromise on profitability.
- First, only ~2.5% of its assets are allocated to stocks with a C+ Quant Profitability rating or lower.
- Second, there is only one cash-burning company in this mix, Constellation Energy (CEG) accounting for a microscopic 55 bps.
- Third, even though the weighted-average Return on Equity is fairly inflated at 87.4% and thus definitely unreliable (owing to H&R Block’s (HRB) gargantuan ROE of 11,355.13%), the WA Return on Assets is still robust at 12.5%.
- Fourth, the WA 24-month beta stands at 0.85, which makes QDEF a true low-volatility play.
What past performance and dividends could tell us?
In the 61-strong cohort of dividend ETFs I cover (including those leveraging international equity-centered strategies, etc.), the median 3-year total return is close to 43%. QDEF that delivered only 39% looks fairly bleak, with the top reason being its poor performance in 2020 (a 3.2% TR). The silver lining is that most plays in the cohort have been performing rather poorly this year, with the median price return at negative 1.6%, while QDEF is up almost 4%; one-year return tells a similar story, as this FlexShares fund is one of the 26 ETFs in the pool that have delivered a positive return.
The table below combining performance data for QDEF, QDF, IVV, and the iShares Russell 1000 ETF (IWB) should provide better context.
Created by the author using data from Portfolio Visualizer
Here, QDEF is not a leader, though with the lowest standard deviation in the group.
Regarding dividend characteristics, the ETF again does not look like a top pick. Even though it is among 26 funds with an A (-/+) ETF Dividends rating in my pool, which is undergirded by its 10-year CAGR and 9 consecutive years of payments, its 2.3% yield is rather subdued for my taste, while a negative 7.7% 3-year CAGR (below the 4.4% median in the cohort) looks worrisome.
QDEF’s dividend strategy mindful of volatility and quality looks alluring at first blush, but the reality is that its results are far from excellent. Valuation is not perfect, while growth is subdued. Its low dividend yield, negative 3-year dividend CAGR, and mixed past performance are other reasons for skepticism. In sum, I believe there is no sufficient reason for a Buy rating.