Selecting Dividend Aristocrats Using the SCHD Methodology (NYSEARCA:SCHD)

Darren415

Schwab’s U.S. Dividend Equity Fund

Schwab U.S. Dividend Equity Fund (NYSEARCA: SCHD) is one of the most popular dividend ETFs on the market. The fund offers an attractive dividend yield of around 3.7%, has a history of above-average dividend growth and a long-term total return that rivals the S&P 500. Did I mention its exposure ratio is only 6 basis points. What more could a dividend investor ask for?

If you look under the hood of SCHD, you’ll find that the fund tracks the Dow Jones US Dividend 100 Index, which is designed to measure the performance of high-yielding US stocks with consistent dividend histories. What I propose is to borrow the stock selection process from the index and apply it to the Dividend Aristocrat’s universe of stocks with the intention of generating alpha. To do this, we must first understand how the US Dividend 100 Index works.

Dow Jones US Dividend 100 Index

The US Dividend 100 Index methodology is quite simple to understand and duplicate. Here is a link to the S&P methodology Global website, the US Dividend 100 methodology can be found on page 19. HHere is a brief explanation of how it works.

The index uses the Dow Jones US Broad Market Index, excluding REITs, as the equity universe. As of September 30, 2022, there were 2524 constituents in the US Broad Market Index. The US Dividend 100 Index applies 3 filters as an initial filter to bring this long list of stocks down to a manageable number. They are:

  1. Minimum 10 consecutive years of dividend payments.
  2. Minimum float-adjusted market capitalization of US$500 million.
  3. Three-month minimum average daily trading volume of US$2 million.

These 3 controllers alone reduce the universe of shares from 2524 to a few hundred. The next step is to sort all stocks that pass in descending order by IAD yield (indicated annual dividend) not counting special dividends. The top half of actions based on this ranking are considered for selection.

The historical dividend measurement date is the last business day of December. While free float-adjusted market capitalization and average daily trading volume are measured as of the last business day of February.

Then, each of the eligible actions is ranked according to the following 4 criteria.

  1. Free cash flow to total debt, defined as annual net cash flow from operating activities divided by total debt. Companies without debt are ranked first.
  2. Return on equity, defined as annual net income divided by total equity.
  3. IAD yield
  4. 5-year dividend growth rate, defined as the previous year’s dividend rate divided by the average dividend rate for the previous 5 years, minus one.

The 4 rankings are weighted equally and combined into a composite score which is used to rank all eligible stocks.

The top 100 ranked stocks are selected to be part of the index with the following 3 buffer rules.

  1. Constituent stocks will remain in the index as long as they rank in the top 200 based on the composite score.
  2. Non-constituent stocks are added to the index until the number of constituents reaches 100.
  3. If two non-constituent stocks have the same composite score, the stock with the highest IAD yield will be selected first.

The reference date for all criteria is the last business day of December except for the IAD return which is calculated on the last business day of February.

The index is weighted quarterly using a capped float-adjusted market capitalization method. No constituent may have an allocation greater than 4% and no sector weight may exceed 25%.

A daily weight cap check is performed to determine if the index needs to be rebalanced. If the sum of stocks with weights greater than 4.7% exceeds 22%, the index is reweighted. The weighing takes place two working days after a default, according to the quarterly weighing method.

Dividend Aristocrats

The Dividend Aristocrats are an elite group of stocks with long and strong dividend growth. They make great basic additions to any dividend portfolio, providing security and stability during all market times. However, not all Dividend Aristocrats are equal, while they have all experienced periods of at least 25 consecutive years of dividend growth, some continue to grow faster than others. I have already followed and published a method for selecting the best dividend aristocrats here on alpha research, based on dividend yield theory and future earnings per share forecasts. What I propose now is another method of selecting the best dividend aristocrats, borrowing the methodology of SCHD, or rather its underlying index.

I took the set of 4 criteria used to rank stocks eligible for the Dow Jones US Dividend 100 Index and applied them to the Dividend Aristocrats to see which Aristocrats would rank best.

All of the data needed to perform this stock picking process can be found here on alpha search. The only exception is that you cannot directly find the ratio of free cash flow to total debt, it must be self-calculated using two separate numbers. Here’s how the 64 Dividend Aristocrats ranked as of October 14, 2022.

Symbol FCF to Debt Return on equity Yield AT Div growth 5 years Composite
TRUE 1100.00% 24.78% 4.88% 15.77% 40
ABBV 31.32% 92.71% 3.95% 17.26% 48
ITW 29.02% 76.75% 2.82% 12.73% 70
OSA 150.86% 28.66% 2.45% 15.71% 70
ADP 86.32% 66.30% 1.84% 12.78% 71
EXPD 289.30% 46.70% 1.49% 8.80% 85
TGT 28.75% 33.19% 2.97% 9.33% 87
CLX 24.91% 71.31% 3.60% 7.54% 89
ETG 49.65% 38.42% 1.21% 24.64% 89
PG 51.79% 31.64% 2.92% 5.58% 94
KMB 31.02% 242.13% 4.10% 3.82% 96
CLC 151.99% 20.24% 3.55% 5.33% 97
ABT 60.82% 24.18% 1.86% 12.14% 97
MMM 34.99% 29.38% 5.25% 5.12% 98
Well 40.54% 14.24% 5.34% 7.71% 99
ODA 39.64% 16.17% 2.79% 11.38% 101
JNJ 72.34% 25.17% 2.75% 5.95% 101
AFL 40.78% 14.46% 2.71% 12.21% 103
DYNAMISM 28.76% 55.71% 2.70% 7.39% 104
NUDE 120.49% 62.28% 1.68% 5.78% 107
XOM 136.44% 23.05% 3.55% 2.98% 111
GD 43.88% 20.23% 2.28% 8.67% 111
SYY 15.73% 90.53% 2.66% 7.78% 112
CL 37.74% 297.32% 2.64% 3.09% 112
CAT 15.42% 41.41% 2.69% 7.95% 120
WST 203.07% 30.76% 0.29% 6.72% 121
MTD 30.75% 10.00% 3.33% 8.04% 122
CINF 205.54% 4.84% 2.79% 6.40% 122
KO 27.20% 39.21% 3.20% 3.57% 123
CPG 32.65% 31.98% 2.32% 5.46% 123
HRL 39.97% 14.15% 2.32% 8.87% 124
SHW 13.46% 69.30% 1.19% 15.77% 124
GWW 35.83% 60.36% 1.37% 5.96% 128
IBM 18.41% 27.09% 5.50% 3.50% 129
VFC 6.74% 30.37% 6.91% 4.81% 130
LINEN 61.85% 8.34% 1.70% 8.25% 135
BF-B 41.10% 32.60% 1.18% 5.24% 139
DOWN 27.37% 0.00% 2.22% 18.77% 141
DVV 26.46% 28.18% 1.69% 6.77% 144
SPGI 22.37% 16.71% 1.19% 15.30% 144
CHD 32.18% 22.51% 1.45% 6.83% 146
CDMA 21.33% 18.19% 4.43% 0.00% 149
WBA 10.99% 14.91% 5.78% 4.63% 153
ATO 12.61% 8.82% 2.77% 8.73% 153
PNR 43.10% 23.32% 2.06% -2.11% 154
MKC 13.08% 15.40% 2.01% 9.50% 155
HAC 53.39% -171.32% 2.91% 1.60% 160
SWK -11.29% 9.33% 4.18% 5.99% 161
BORN 13.92% 3.74% 2.37% 11.71% 162
HSE 16.23% 6.70% 3.95% 4.87% 164
EMR 21.10% 24.94% 2.63% 1.42% 165
GPP 10.68% 17.23% 2.25% 7.69% 165
CC 51.25% 12.82% 1.76% 3.09% 166
BROTHER 20.41% 14.91% 0.69% 8.71% 168
MCD 16.87% 0.00% 2.50% 7.98% 170
O 12.14% 2.94% 5.36% 3.94% 173
ADM 23.23% 15.68% 1.92% 4.50% 173
ECL 19.11% 16.19% 1.46% 6.63% 173
ORP 19.28% 8.19% 0.68% 12.12% 173
WMT 31.24% 16.20% 1.72% 1.93% 175
TRF 11.61% 9.89% 4.84% 1.72% 177
OF 12.57% 7.19% 3.86% 2.80% 185
BDX 17.48% 8.02% 1.55% 3.84% 206
ALB 0.52% 5.66% 0.67% 4.48% 233

The table above shows the value of each of the 4 criteria used for the rankings as well as the combined composite score. A lower composite score is preferable. The 5-year dividend growth rate used for this analysis is the rate reported by alpha research and not calculated as defined by the Dow Jones US Dividend 100 Index.

Additionally, Lowe’s (LOW) and McDonald’s (MCD) have no return on equity as both companies have negative equity.

My intentions for this stock selection process

What I intend to do with this information is to track my own index, using a process similar to that outlined in the US Dividend 100 Index methodology. I will select a subset each year Dividend Aristocrats and apply a similar free float-adjusted capped market capitalization method to determine their weightings. My initial idea is to select the top 30 Dividend Aristocrats and use a cap above the US Dividend 100 index. I will use twice the equal weight allocation which would be 6.67% if 30 Aristocrats are selected . I will not apply any cap to sector allocation and waive daily weight cap checks. The index will be created on January 1, 2023 and rebalanced on an annual basis.

The primary objective will be to generate a higher total rate of return than the ProShares S&P 500 Dividend Aristocrats ETF (NOBL). I will also be tracking this index against Schwab’s US Dividend Equity ETF to compare its performance.

I will likely be documenting this index here on Seeking Alpha starting in Q1 2023. You can also find more content related to this index on my YouTube channel, link in my bio.

About Catherine Wilson

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