VYM: Betting On Price Appreciation

The Vanguard High Dividend Yield ETF (VYM) is a great way to get diversified exposure to a range of high yield dividend stocks. Like much of the rest of the market, VYM has had a good year. The stock is up 24.3% year to date and has delivered another 3.5% of dividends based on the 12/31/2012 closing price of $49.38. In contrast, the SPDR S&P 500 Trust ETF (SPY) is up 27.5% with another 2.4% from dividends. The question is whether or not VYM remains a good investment opportunity, and also, what additional analysis would be worth conducting prior to making an investment.

At first glance, SPY looks like it has been the better investment in absolute terms. However, this is with the benefit of hindsight. Consider the following table:

SPY vs. VYM

Ticker	SPY	VYM	SPY/VYM
Appreciation	27.49%	24.34%	113%
Dividends	2.35%	3.54%	66%
Total Return	29.84%	27.88%	107%
Risk Free Estimate	1.76%	1.76%	100%
Market Risk Return	28.08%	26.12%	107%
Beta	1.0	0.8	123%

Source: Yahoo!Finance, author calculations

First, this analysis looks at the capital asset pricing model and considers the concept of beta as a measure of risk based on the historical return relationship between VYM and SPY. The second and third columns show the various values of SPY and VYM. SPY delivered a greater return, while VYM had more dividends. One can then take out the risk free rate estimate to get the return from market forces. Here SPY is about 2% higher than VYM. However, VYM has a substantially lower beta than SPY, suggesting that on a risk adjusted basis, VYM actually did better than SPY.

What conclusions can we draw from the beta analysis?

First, if you don't subscribe at all to CAPM, there is not much to draw from a CAPM based analysis. However, how could one reconcile these facts? Perhaps there is an expectation that VYM will decline or SPY will appreciate and bring the values more in line. This type of analysis is based on point in time figures while markets are dynamic and continuously changing. VYM might perhaps be overvalued right now. Alternatively, SPY could be undervalued right now.

What else should we consider looking forward?

The other interesting observation for VYM is that the dividend yield is very close to the 10 year treasury bond yield. The TTM dividend yield on VYM is 2.85% while the 10 year yield is at 2.89%. While there will most likely be some dividend appreciation, potentially 8-20% based on historical figures that would contribute another 0.2% to 0.6% return, most of the return above the risk free rate will come from price appreciation in the holdings of VYM.

This trend has been emerging over the last couple years as seen in the graph below.

(click to enlarge)

Source: Yahoo!Finance, author calculations

This graph shows the historical progression of the TTM dividend yield for VYM vs. the ten year treasury bond yield. The spread between the two is in green. The spread was negative prior to the financial collapse when stocks carried relatively higher valuations with relatively lower yields. The spread also went negative in 2009 as dividends were drastically cut and the ten year was still in decline.

Looking forward

So if the yield between VYM and the ten year bond is the same, one is really betting that VYM will deliver superior price appreciation. With interest rates trending upward, one would expect bonds to continue a slow decline, while a strengthening economy should provide uplift to VYM. However, this does shift to the question of whether VYM is fairly valued. VYM carries a P/E that is somewhat less than the broader market which is an appropriate position. VYM holdings typically pay out a higher portion of their earnings as dividends than the broader market. This leaves less cash available to reinvest in the business and drive growth. From this perspective, VYM still looks like a reasonable investment within the context of seeking broader market exposure. However, its future performance might not be as strong as its more recent performance.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security. I am long VYM and expect to add to that position in the near future.

Source: VYM: Betting On Price Appreciation

Disclosure: I am long VYM, SPY. 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. (More...)

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