Undervalued SCHD Components Strategy

Overview

This lecture explains how dividend investors can potentially double the yield from SCHD (Schwab U.S. Dividend Equity ETF) by targeting its most undervalued components using a systematic, valuation-based selection and portfolio management process.

SCHD Investing: Standard vs. Strategic Approaches

• Most SCHD investors buy the whole ETF, gaining steady dividends but missing opportunities from undervalued components.
• SCHD’s methodology selects high-quality, dividend-growing companies but does not consider if holdings are overvalued or undervalued.
• Buying the full ETF includes both reasonably priced and overpriced stocks, reducing yield and return potential.
• The top 10 holdings make up over 41% of SCHD, increasing exposure to potentially overvalued stocks.

The Case for Targeting Undervalued Components

• Valuation differences among SCHD holdings create a significant performance gap.
• Focusing on the most undervalued stocks historically outperforms the index by 3–5% annually.
• Example: Verizon trades below historical valuation and offers a higher yield than SCHD’s average.
• Market volatility can increase valuation gaps, offering more opportunities for strategic purchases.

Five-Step System for Identifying Undervalued Stocks

• Step 1: Screen all 101 SCHD holdings for PE ratios below 5-year averages and above-average dividend yields.
• Step 2: Check quality indicators (debt/equity, dividend coverage, return on equity, cash flow trends).
• Step 3: Set entry points at the lower end of historical valuations and use alerts for systematic buying.
• Step 4: Size positions based on undervaluation levels while maintaining sector diversification.
• Step 5: Define exit criteria using target profit/valuation levels to remove emotion from selling.

Implementation Strategies

• Core and Satellite: Keep 70–80% in SCHD, allocate 20–30% to undervalued components.
• Valuation Triggered: Only buy components when valuation targets (e.g., PE 20% below average) are met.
• Sector Rotation: Overweight sectors within SCHD that are undervalued versus historical norms.

Risk Management

• Concentration Risk: Limit single stock positions to 3–5% and ensure sector diversification.
• Value Traps: Monitor dividend coverage and cash flow trends to avoid stocks with hidden problems.
• Tax Efficiency: Prefer tax-advantaged accounts (IRA/401k) to improve after-tax returns.
• Take advantage of SCHD’s annual reconstitution and quarterly rebalancing to find mispricings.

Key Terms & Definitions

• SCHD — Schwab U.S. Dividend Equity ETF, an index fund focused on high-quality dividend stocks.
• Dividend Yield — Dividend payment as a percentage of stock price.
• PE Ratio — Price-to-Earnings ratio, a common valuation metric.
• Value Trap — A stock that appears undervalued but has fundamental problems.

Action Items / Next Steps

• Set up a stock screener for SCHD components using valuation and quality filters.
• Choose one of the suggested strategies and start with a small allocation.
• Regularly monitor portfolio risks and tax implications.
• Review SCHD rebalancing/reconstitution periods for buying opportunities.