First Trust Value Line Dividend Index Fund Is Overvalued – Wait For A Pullback

ETFS

ETF Overview

First Trust Value Line Dividend Index Fund (FVD) focuses on dividend stocks based on Value Line’s safety ranking. The safety ranking is based on stock price stability as well as financial strength of these stocks. FVD’s portfolio of stocks are constructed based on equal-weightings and rebalances every month. FVD’s portfolio has higher exposure to defensive sectors than other dividend ETFs. Therefore, it may outperform in an economic downturn but underperform in an economic expansion. FVD is currently overvalued due to its exposure to the utilities sector. We think investors may want to wait for a pullback before initiating a position.

Chart

Data by YCharts

Fund Analysis

Portfolio construction focusing on safety rather than yield

Unlike many other funds that include stocks in their portfolio based on dividend yields, FVD selects stocks based on Value Line’s safety ranking. The safety ranking is based on the stock’s price stability (past 5-year weekly volatility) and financial strength rating. This selection criteria is beneficial as it will not blindly choose high-yielding stocks that have inferior balance sheets or with high payout ratios. The fact that the selection ranking based on stock volatility also adds another safety nest as lower volatility stocks reduce the chance of selecting high-risk stocks where earnings can fluctuate quickly (e.g. cyclical stocks).

Slightly higher exposure to defensive sectors

FVD’s selection criteria helps it to reduce its exposure to cyclical stocks. In fact, cyclical stocks such as stocks in financials, industrials, information technology, materials and energy sector represent only about 46% of its total portfolio. The rest are mostly defensive stocks. As can be seen from the chart below, utilities, consumer staples, healthcare, real estate, and communication services represent about 48% of its total portfolio.



Source: First Trust Website

FVD’s slightly higher exposure to defensive sectors can be advantageous in an economic downturn, or when the uncertainties are high. This is because capitals tend to flow from cyclical sectors to defensive sectors. This is evident in the fact that FVD outperformed other dividend ETFs that have higher exposure to cyclical sectors in 2019. As can be seen from the chart below, FVD’s fund price increased by 20% since the beginning of this year. This is much better than Vanguard High Dividend Yield ETF’s (VYM) 14.4%. For the reader’s information, VYM has higher exposure to cyclical sectors than FVD.

Chart

Data by YCharts

FVD appears to be expensive

Below is a table that compares the valuation of FVD to the Vanguard High Dividend ETF (VYM) and the S&P 500 Index.

As at 2019/10/24

FVD

VYM

S&P 500 Index

Forward P/E Ratio

16.88x

14.62x

18.08x

Dividend Yield (%)

2.19%

3.14%

1.83%

Sales Growth (%)

5.04%

4.43%

7.05%

Cash Flow Growth (%)

6.41%

8.75%

13.32%

Source: Morningstar, Created by author

FVD’s forward P/E ratio of 16.88x is several multiples higher than VYM. This is not surprising, given its nearly 22% exposure to the utilities sector. This sector’s valuation has expanded significantly in the past year expanding by several multiples to over 21x. While FVD has a higher valuation than VYM, its cash flow growth rate of 6.41% is lower than VYM’s 8.75%. Therefore, we think FVD is overvalued right now. In addition, if the U.S. economy stabilizes and GDP growth re-accelerates, share prices of stocks in defensive sectors may be under pressure as capital flows from defensive sectors towards cyclical sectors.

Risks And Challenges

Since FVD rebalances its portfolio every month and caps each stock’s weighting to 0.5%, the turnover ratio can be quite high. In fact, its 2018 turnover ratio is 58%. In addition, FVD’s management expense ratio of 0.70% is also quite high.

Investor Takeaway

We like FVD’s selection criteria to focus on safety. However, its shares are currently overvalued due to its higher exposure to defensive sectors especially the utilities sector. Therefore, we think investors may want to wait for a pullback before initiating a position.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

Products You May Like