Eric Ervin, the CEO of Reality Shares, is concerned enough about the stock market that he favors a strategy that includes betting on a decline in prices heading into 2018.
Stock valuations are “continuing to be pressed further and further,” he said in an interview on Dec. 15. “The growth rates of a lot of these companies cannot sustain these multiples, so it is frightening.”
Reality Shares runs four exchange traded funds (ETFs) built around its Divcon stock-rating methodology.The firm was founded in 2012 and is headquartered in San Diego, with $145 million assets under advisement.
The Divcon methodology is designed to identify companies that are most likely to raise or lower dividends. A company’s Divcon rating ranges from 1 to 5, with 5 being the strongest ranking and indicating a high likelihood of a dividend increase. It makes no difference how high the dividend yield is. The idea is that companies that are well-positioned for dividend increases are more likely to be better stock-market performers over time.
The Divcon rating encompasses free cash flow/dividends, earnings growth, dividend actions, stock repurchases and other indicators.
Divcon ratings for the 1,200 largest publicly traded U.S. companies are available here. If the company doesn’t pay a dividend on common shares, it won’t have a Divcon rating.
For example, Lockheed Martin Corp. LMT, -0.17% has a Divcon rating of 5. A scan of data supplied by FactSet shows that the company is paying annual dividends of $8 a share, while its free cash flow over the past 12 months totaled $15.82 a share. So the dividend has been very well-covered.
Here’s another example: CoreCivic Inc. CXW, +0.87% (which changed its name from Corrections Corp. of America last year) has a Divcon rating of 1. The company is paying annual dividends of $1.68 a share, while its free cash flow over the past year has been $2.05 a share. This makes it appear the company is comfortably covering the dividend. However, CoreCivic cut its quarterly dividend payout by 22% in December 2016.
ETFs
Reality Shares runs four ETFs based on Divcon. The first three listed here were established in January 2016, while the Reality Shares DIVS ETF DIVY, +0.49% was established in December 2014.
• Divcon Leaders Dividend ETF LEAD, -0.06% — Invests in the largest U.S. companies that have the greatest probability of raising dividends over the next 12 months, based on Divcon scores.
• Divcon Dividend Defender ETF DFND, -0.29% — Invests in the largest U.S. companies that have the greatest probability of raising dividends over the next 12 months, while investing 25% in short positions in companies with the highest probability of cutting dividends over the next 12 months, based on Divcon scores.
• Divcon Dividend Guard ETF GARD, +1.61% — The allocation of this ETF depends on Reality Shares’ Guard Indicator, which forecasts the direction of the S&P 500 Index SPX, +0.20% based on technical measures of price volatility. Right now, GARD is invested the same way as LEAD. But if the Guard Indicator forecasts a market decline, up to 50% of the fund can be invested in short positions, making for more aggressive hedges and downside protection than DFND. However, the nature of the technical volatility indicators means “the market can decline 10% by the time the fund goes short,” Ervin said.
• Reality Shares DIVS ETF DIVY, +0.49% — This ETF is designed to protect investors from price volatility while generating a return to capture some of the increase in dividends for large-cap companies. The fund invests in dividend swaps. Ervin called its strategy an “alternative to bonds.”
Ervin said that even though the Guard Indicator indicates continued strength for the stock market, his gut feeling for 2018 is that investors are facing increased risk as stocks trade ever higher when compared with earnings. This chart shows the price-to-earnings ratio for the S&P 500, based on trailing 12 months’ earnings, since the end of 1999:
You can see that we’re nowhere near the lofty valuations of early 2000, when the dot-com bubble was getting ready to burst, but the market is trading higher, by this measure, than it has at any time since July 2002.
“The Divcon Dividend Defender ETF DFND, -0.29% is interesting, because I don’t know when the market corrects,” Ervin said.
Performance and leaders
Here’s how the four ETFs have performed this year, compared with the S&P 500:
| Total return - 2017 through Dec. 18 | |
| Divcon Leaders Dividend ETF | 23.9% |
| Divcon Dividend Defender ETF | 15.9% |
| Divcon Dividend Guard ETF | 17.9% |
| Reality Shares DIVS ETF | 4.7% |
| S&P 500 Index | 20.5% |
| Source: Morningstar | |
So the Divcon Leaders Dividend ETF has outperformed the S&P 500 this year, which may not be surprising, given its emphasis on factors supporting dividend growth during a very strong year for the stock market. The Dividend Defender strategy will underperform during a strong period for stocks. The Dividend Guard ETF has underperformed LEAD and the S&P 500 this year because it took short positions for several months early this year. The Reality Shares DIVs ETF, because of its completely different objective of capturing returns from dividend increases while avoiding price volatility, cannot fairly be compared to the other ETFs.
Reality Shares rebalances the LEAD, DFND and GARD ETFs each year early in December. Here are eight companies that have made the Divcon Leaders list three years in a row:
| Company | Ticker | Total return - 2017 through Dec. 18 | Total return - 3 years | Total return - 5 years |
| Estee Lauder Cos. Class A | EL, -0.09% | 72% | 78% | 126% |
| Expeditors International of Washington Inc. | EXPD, -0.51% | 24% | 55% | 78% |
| Nike Inc. Class B | NKE, +1.86% | 29% | 38% | 179% |
| Starbucks Corp. | SBUX, -0.26% | 0% | 52% | 130% |
| Tractor Supply Co. | TSCO, +1.95% | -7% | -7% | 68% |
| Tyson Foods Inc. Class A | TSN, -0.21% | 36% | 116% | 341% |
| Texas Instruments Inc. | TXN, -0.70% | 45% | 105% | 276% |
| Visa Inc. Class A | V, +0.26% | 47% | 76% | 213% |
| Sources: Reality Shares, FactSet | ||||