Ep. 86: Building a Dividend Core — SCHD vs VOO, the Anchor That Survives a Crash, Quality on Sale (MSFT & ADP) & the Honest Income Zoo

What if I told you that a 14% dividend yield could actually leave you poorer over a decade
than a boring 2% yield?
I mean, it sounds completely backward.
It really does.
But in the dividend investing world, the shiny roof of a massive headline yield is,
like, blinding investors to a crumbling foundation.
We see a double digit payout, and we just assume the structural integrity of the fund is solid.
And that is the single most common and, frankly, most expensive mistake income investors make.
Chasing the distribution rate, while completely ignoring the underlying net asset value,
a high yield is entirely meaningless if the principle you invested to get it is just, you know,
slowly evaporating.
And that is the exact warning light we are flashing for you today.
Ah!
Welcome to The Deep Dive.
We have a massive stack of six highly detailed financial sources to go through,
and we're looking at ETF screening methodologies.
Deep dives into single stock valuation.
That's a fun stuff.
Yeah, exactly.
And we're analyzing some of the newest, most heavily engineered options income funds on the market right now.
Our mission today is twofold.
Figure out how to build a practically unbreakable dividend core,
and then, honestly, evaluate the flashy income add-ons that are aggressively marketing to you right now.
So, to do that, we really have to establish the non-negotiable rule right from the jump.
Based on the data in these sources, total return matters more than headline yield.
Always.
Always yield does not equal return.
You have to ruthlessly validate the mechanics of an amazing yield before you trust it with your capital.
Okay, so I want to start with a debate that I know is running through the minds of anyone holding
a portfolio right now. I hear it all the time. Do you even need a dividend core when the broader
market is just tearing upward?
Right, the classic question.
I mean, you look at Nvidia, you look at Meta, and you have to wonder why you'd ever buy a boring
dividend ETF when the S&P 500 is just flying.
It is the ultimate passive investing standoff, and the sources frame this perfectly by putting S&HD,
you know, the Schwab, U.S. dividend equity ETF, which is basically a roughly 100 company quality
screen with a high starting yield, right?
Yeah, exactly. They put S&HD up against the heavyweight champion, VOO, the Vanguard S&P 500 index.
Right, because S&HD has an average quality score of, I think, roughly 69 out of 100.
It's solid, but it's not, you know, flashy.
No, not all.
And VOO is about 500 names super heavy on megacap tech.
So the assumption is always that S&HD is just for the cash flow, and VOO is where you actually
make your money over the long haul.
But the data and the research challenges that completely.
Over long periods, the historical total returns of S&HD and VOO actually converge to a shocking degree.
Wait, really?
Yeah, they end up in nearly the exact same place.
Come on. I mean, I'm looking at tech stocks tripling over the last couple of years.
You're telling me a fun full of industrials and consumer staples catches up to that.
It does, but only through a very specific mechanism.
It's the aggressive reinvestment of S&HD's larger dividend payouts.
Oh, when you aren't spending that yield, and instead you're using the higher cash flow to
automatically buy more shares, especially during market downturns when those shares are cheap,
you create a compounding machine.
That makes a lot of sense.
So that reinvested cash flow bridges the performance gap between a high-quality dividend screen
and a roaring tech-heavy index.
It's exactly right.
The S&P is relying on pure price appreciation, but S&HD is using its cash flow to constantly
increase your share count. It really highlights how flawed the whole growth versus income mindset is
for long-term investors.
It's a false binary.
Yeah, you don't have to pick just one.
If S&HD is providing the reliable, passive cash flow that builds a muscle of the portfolio,
VOO is providing the market-driven growth energy.
Owning both, reinvesting the dividends is how you build a resilient core.
And that concept of resilience brings us to the next critical layer.
If S&HD is one anchor in that core, how do we evaluate the others?
Because across all our sources, the recurring theme is that a dividend ETF is only as strong
as its screen.
The screening methodology isn't just a list of rules.
It dictates exactly how the fund will behave when the market breaks.
I want to test that against some specific funds from the notes.
Because DGRO, the eye share's core dividend growth ETF really stands out here.
You'll for sure.
The expense ratio is practically zero, just 0.08%.
But its screen is incredibly conservative.
It lops off the top 10% highest yielding stocks immediately.
Which a lot of people hate.
Right. But it demands five straight years of dividend growth.
In it institutes a hard cap, a sub 75% payout ratio.
And that payout ratio requirement is the crucial mechanism.
Like you said, a lot of investors hate it because it filters out some massive yields.
But mathematically, if a company's forced to maintain a payout ratio under 75%,
it means they are retaining at least 25% of their earnings.
Okay, a buffer.
Yes, a mandated financial buffer.
When a recession hits and revenues plummet, that 25% buffer is what prevents the company
from having to slash its dividend.
It's the primary reason DGRO only dropped about 8% during the brutal 2022 bear market.
But doesn't that massive buffer mean you miss out on the giant bull runs?
I mean, DGRO is safe, but there are funds absolutely blowing past it right now.
Well, yeah, like FDVV, the Fidelity high dividend ETF.
Has an expense ratio of 0.15% it's yielding around 3%,
but it's been crushing SHD lately.
It has, but we have to look under the hood at how it's doing that.
FDVV scooped up big tech, Apple, Microsoft, and video make up about 18% of the fund,
alongside a heavy allocation to REITs, which looks brilliant on paper right now.
On paper in a bull market, yes.
But FDVV's screening methodology is vastly different from DGRO.
FDVV weights yield heavily, like about 70% of its screen is driven by yield.
Wow, that's high.
It is.
And more importantly, it calculates that yield and its dividend growth metrics
using only a trailing 12-month look back.
There is no five-year history requirement.
Wait, so it just looks at what a company did over the last year and assumes that's the new normal.
Precisely.
And that mechanism is a double-edged sword.
In a raging bull market, a trailing 12-month screen is fantastic,
because it aggressively captures new, rapidly-growing dividend payers,
like the tech giants who recently initiated or bumped their payouts.
Right, right.
But in a crash, it's a massive liability.
Because it hasn't stressed tested those companies.
Exactly.
It catches companies that have zero proven history of maintaining a dividend under pressure.
The research highlights the 2020 Black Swan event as the perfect example of this.
Well, what happened then?
Because FDVV's screen allowed in all these unproven payers
when the panic hit,
those newer dividend companies were the first to slash their payouts to survive.
FDVV bled roughly 10% more than SCHD during that crash.
That is a stark reality check.
Just because an ETF has the word dividend in the name doesn't mean it's actually playing defense.
Not at all.
Which is why the third fund in our sources is so interesting.
CGDV, the capital group dividend value ETF.
It's an actively managed ETF.
It has five different portfolio managers.
The expense ratio is higher at 0.33%,
and the yield is lower, around 1.5%.
But the performance metrics are what actually matter here.
Exactly.
Since it launched in February 2022,
it has beaten both the S&P 500 and the tech heavy QQQ.
And during the 2022 bear market, it only dropped 2.8%.
That's incredible.
It really is.
And it did all of that without heavily relying on the big tech names that drove FDVV.
And this just proves that active risk management and strict payout discipline
can actually outperform passive yield chasing even neta fees.
The human managers at CGDV were able to evaluate the true survivability of a balance sheet
in real time, rather than relying on a blind 12-month trailing algorithm.
It reinforces the core lesson.
Screen for quality and survivability, not just the highest current payout.
All right, so we've got a solid blueprint for the Broad ETF Foundation.
SCHD, VLO, DGRO, maybe CDEV if you want active management.
But the research doesn't stop at ETFs.
No, because deeper, once you have that core, the sources argue you should hunt for individual,
high quality dividend growth names that are fundamentally mispriced.
Basically building the core with single stocks.
Right.
And the loudest name in the research stack is Microsoft, ticker, MSFT.
The argument for it being on sale is compelling at first glance.
You look great.
It's down roughly 20% year to date.
It's trading at a forward PE of 22.55, which is the bottom 10% of its five-year range.
And the cash flow looks incredible.
Operating cash flow is 36% below fair value,
growing an 18.25% compound annual growth rate.
Yeah.
Every traditional value metric is screaming that Microsoft is cheap.
But, and this is a big but, if you rely solely on operating cash flow and trailing PE
for a tech company undergoing a massive infrastructure shift,
you are going to get burned.
Okay, why is that?
The source material raises a massive red flag when you switch the metric to free cash flow.
Microsoft is only about 7% below fair value on a free cash flow basis,
and it's barely budging with just a 5.6% CAGR over five years.
Well, I'm trying to score those two numbers.
If operating cash flow is booming,
but free cash flow, the actual money left over after they reinvest into businesses
practically stagnant, where's all that cash going?
Capital expenditures, specifically AI data centers.
Over the trailing 12 months,
Microsoft's CAPEX hit an astonishing $100 billion.
$100 billion in a single year.
In a single year?
How does a software company physically spend that much cash?
By buying a land, massive amounts of high-end specialized silicon from NVIDIA,
and the immense power generation and cooling systems required to run them,
to put that 100 billion in perspective in 2022,
their entire CAPEX was under $23 billion.
Wow.
They have quadrupled their infrastructure spend in two years.
That completely changes the valuation math.
I mean, if they are pouring that much cash into physical hardware,
the multi-billion dollar question for anyone buying Microsoft right now is,
what return on invested capital are they actually going to get on that 100 billion?
And honestly, nobody knows the answer yet.
Historically, Microsoft's ROIC has been exceptional sitting north of 21%.
Right, they've always been great at that.
But those are trailing metrics based on a high-margin software model.
They do not account for these new incredibly capital-intensive infrastructure bets.
So when you see a low PE ratio for Microsoft today,
you aren't buying a cheap software company.
You are buying a massive,
unproven, capital allocation bet on the future of AI computing.
That's a huge distinction.
Okay, so Microsoft is the terrifyingly expensive tech giant transition.
I want to look at the complete opposite end of the spectrum from our sources.
The ultimate boring, but beautiful business.
ADP, automatic data processing.
Oh, the global payroll and HR Titan, a 90 billion dollar company.
Yes, 67% employer services, 33% professional employer organization.
It is the definition of sticky software.
Once a company integrates ADP's payroll into their HR systems,
the switching costs are so high that client retention is nearly 100%.
Once they're in there in.
Exactly, but there's a specific detail in the research about ADP that blew my mind,
the float. They are basically running a bank in the background.
Oh, the float is one of the most brilliant, quiet cash machines in the corporate world.
Yeah. Think about the mechanics of payroll.
Yeah. Employers don't wire money to employees on payday.
They wire the money to ADP several days in advance.
ADP holds those billions of dollars in client deposits
before they actually execute the payroll transfers.
Right.
And during that delay, ADP invests those funds and earns a return on them.
They're earning interest on other people's money before they pass it along.
That is incredible. As interest rates rise,
their revenue just automatically increases without them selling a single new software license.
Yep. It acts as a natural hedge against inflation and a cost-effective source of capital that
just layers right on top of their core software revenue.
And you can see the strength of that business model in their dividend history.
The numbers are staggering. ADP is a 50-year dividend king.
They've raised their dividend through the dot-com buzz,
the 2008 financial crisis, the 2020 pandemic.
They don't know.
They boast a 12.1% 10-year dividend compound annual growth rate,
a very manageable 63.4% payout ratio.
And right now, the yield is roughly 3.1%.
And furthermore, the dividend discount models in the research indicate ADP is sitting at about
10% undervalued right now. When you compare it to Microsoft, ADP is the quintessential
core dividend compounder. Definitely.
You understand exactly how it generates cash.
And there is no 100-billion-dollar CAPX question mark
looming over its balance sheet.
All right, so we've built the Solid Foundation.
We have the ETFs. We have the stable compounders like ADP.
But let's be honest, investors get bored.
They always do.
We inevitably start looking for those high yield dopamine hits.
The sources devote a lot of time to the income zoo.
These flashy, hyper-engineered income add-ons
dominating the market right now.
And the poster child for that currently is the newly launched Curve SpaceX Enhanced Income ETF,
ticker XSHP.
This one is wild.
The SpaceX IPO happens.
And seemingly the very next day, this ETF launches with an expense ratio of 0.99%.
It's marketing itself as a way to turn the incredible volatility of SpaceX into monthly
current income.
This is where investors need to be incredibly skeptical.
Yeah.
This fund is not simply SpaceX stock that happens to pay a dividend.
It is an actively managed options income strategy
overlaid on a brand new ultra volatile story stock.
And if you read the prospectus, the structural risks are glaring.
It is allowed to run synthetic long exposure up to 200% of its net asset value using derivatives.
I want to stop you right there because synthetic long exposure up to 200%
sounds like a recipe for disaster.
How does that actually work?
So its synthetic long means they aren't just buying the underlying stock.
They are using combinations of options, usually buying call options and selling put options
to mimic the price movement of the stock, but using leverage to double the exposure.
The critical flaw here is that SpaceX just went public.
There is zero historical volatility data.
Meaning the options market is just guessing.
Exactly.
You cannot accurately price options contracts without knowing how the stock historically swings,
but it gets worse.
To generate that high monthly yield,
XSHP has to sell call options against its position.
Oh, yeah.
And when you sell call, you are trading your future upside for cash today.
SpaceX is precisely the type of story stock that could rip 20 or 30% higher in a matter of days
on a news catalyst.
But if you own XSHP, you miss that entirely.
Your upside is structurally capped because those calls will be exercised against you,
but because of the synthetic long exposure, your downside is still
fully exposed and potentially leveraged.
So you take all the risk of a volatile tech IPO crashing,
but you give away the upside of it going to the moon just to get a monthly distribution.
Which perfectly illustrates the primary lesson for evaluating these atoms.
The underlying structure of the fund matters far more than the story of the stock at hold.
It's a great point.
Rapping a complex income ETF around AI, Bitcoin, or SpaceX
doesn't change the unforgiving math of options trading.
If the fund mismanages the volatility and the NAV collapses,
that double digit distribution rate will not save you.
Okay, so the structure has to be sound.
But the final set of sources reveals another layer to this.
Even if the structure is brilliant,
where you hold the fund in your portfolio can completely change your real world returns.
The asset location puzzle.
This is vital for anyone holding high yield funds.
I'm looking at two specific NASDAQ 100 income ETFs from the nose.
Both are offering near identical monthly yields,
right around 13.5 to 14%.
At first glance, you might think you could just flip a coin.
Right.
But they have entirely opposite tax and growth profiles.
And the baseline for this comparison is QYLD,
which is the old school covered call fund,
that basically caps all his upside for yield,
meaning it offers zero growth to fight inflation.
And we already know that sacrificing all growth for yield
is a slow death for your purchasing power.
So the industry has evolved.
Right, which brings us to contender number one,
QQQI from NEOs.
It has an expense ratio of 0.68%.
It's a rules-based fund,
and year-to-date it boasts a total return of 10.85%,
with a growth portion of 4.53%.
But the reason QQQI is so highly regarded isn't just the return.
It's the intense tax machinery under the hood.
QQQI specifically uses Section 1256 index options contracts.
And what does that mean for the person actually paying taxes on this yield?
It's a massive advantage.
Under the US tax code, gains on Section 1256 contracts
are automatically taxed at a 60-40 split,
meaning 60% of the gains are taxed at the much lower
long-term capital gains rate,
and only 40% are taxed at the higher short-term rate.
Wow.
Regardless of how long the fund actually held the options,
they could hold them for a day,
and you still get that 60% long-term tax treatment.
It's amazing.
Add in aggressive tax loss harvesting,
and a strategy of returning capital to investors,
and QQQI is hyper-efficient.
OK, so keep that efficiency in mind,
because container number two is KQQQ from Curve.
The expense ratio is higher at 31.99%.
Unlike QQQI, it's actively managed and highly concentrated
in about 25 massive tech titans.
So a totally different approach?
Very different. They don't track an index,
and the even-hold treasuries is dry powder to buy dips.
The year-to-date total return is an incredible 16.62%,
and 9.12% of that is pure growth.
It delivers almost double the growth of QQQI.
It does.
But here's the catch.
Up to 85% of KQQQQ's distributions
are classified as return of capital or ROC.
That makes for some very messy,
potentially unfavorable tax reporting
if you don't know what you're doing.
And this is exactly how we solve the asset location puzzle.
You have two excellent funds,
but you deploy them in totally different accounts.
Because QQQI has that highly optimized section 1256 tax machinery,
it belongs in your taxable brokerage account.
You want to utilize that 60-40 split
where it will actively reduce your tax burden.
It's a KQQQ.
KQQQ belongs in your Roth IRA, or a traditional IRA.
It generates significantly higher total return in massive growth.
And because it sits inside a tax shelter,
that 85% return of capital classification doesn't matter at all.
Of course.
The IRS isn't taxing the distributions inside the Roth anyway.
You capture the higher total return tax free
and you completely avoid the messy tax reporting.
Same 14% income sleeve,
entirely opposite optimal locations.
That is genuinely empowering.
It shifts you from just buying random tickers
to actually assigning a specific job
to a specific asset in a specific account.
It's treating your portfolio like a cohesive system
rather than just a collection of shiny objects.
So let's trace our steps back
through the entire system we built today.
We started by dismantling the false binary
between income and growth,
proving that a balanced core of SCHD and VOO,
powered by reinvested dividends,
will naturally converge over the long term.
We learned that an ETF screening methodology
is its ultimate defense mechanism.
DGROs 75% payout limit actually protects you in a crash,
while FDVV's trailing 12-month screen
leads you completely exposed to dividend cuts
when the market turns.
We also established that single stock valuations
require looking past the headline metrics.
Microsoft's trailing PE might look cheap,
but its stagnant free cash flow
and $100 billion AI CapEx demands serious scrutiny
about future returns.
On the flip side,
ADP's ability to monetize payroll flow
makes it a deeply undervalued
50-year reliable compounder.
And finally, when you enter the income zoo,
structure and location dictate everything.
Don't let the narrative of a story stock
like SpaceX blind you to the severe risks
of capped upside
in a highly leveraged fund like XSHP.
Never.
It always optimizes your location.
Put the tax-efficient QQQI in your taxable count
and let the high-grows QQQ run unhindered inside your raw.
But as we close the books on these sources,
there is one final structural shift we have to consider.
We talked about Microsoft pouring $100 billion
into physical data centers and power generation.
If the largest technology companies in the world
are increasingly spending hundreds of billions of dollars
to build the physical backbone of AI computing,
they are effectively transitioning
into capital-intensive utility-like infrastructure companies.
Like the railroads
of the telecommunication monopolies of the past.
Exactly.
So the provocative question for the 2030s is this,
will the very definition
of a traditional dividend stock fundamentally change?
That's a great question.
As consumer staples and industrial struggle to grow,
will these new tech infrastructure giants
become the dominant high yield dividend anchors of the future?
That shift would rewrite the screening roles
of every single ETF we discussed today.
It makes you realize that the foundation of the market
is never truly static.
You have to keep inspecting the colon creed.
I highly encourage you to pull up your own portfolio today.
Don't just look at the yield column.
Look at the payout ratios.
Check the free cash flow
and ensure the roof isn't the only thing
holding your financial house together.
Thank you for joining us on this deep dive.
We will catch you next time.