Why Vanguard Dividend Appreciation Is a Core Holding for Your Portfolio

Warren Buffett became the world's most successful investor -- if we take him at his word -- by investing in excellent companies at reasonable prices. While this sounds oh so simple at first, many a Fool has come to realize that this is easier said than done.

That's why I've turned to the Vanguard Dividend AppreciationETF (NYS: VIG) . It's a CAPScall and has been my largest personal holding since November 2008.

The details
Vanguard Dividend Appreciation is an ETF that tracks the Dividend Achievers Select Index, which includes only high-quality dividend stocks. The index starts with all the U.S. stocks that have increased their dividend for at least 10 consecutive years. These companies are then screened again by a proprietary computer algorithm for financial strength, discarding weaker companies.

The few remaining companies are then market-cap-weighted in the portfolio. This screening and reweighting process happens once per year, keeping transaction costs borne by the fund low, with turnover of only around 10% per year.

The result is something rather unique in the ETF world: an amazingly diversified portfolio of 127 mostly Buffett-like companies. It's enough to make me think of the ETF as a "Robo-Buffett."

As a testament to the ETF's screening methodology, five of the Vanguard ETF's top 10 holdings are also part of Berkshire Hathaway's (NYS: BRK.B) top 10 holdings: Coca-Cola, IBM (NYS: IBM) , Wal-Mart, Conoco-Phillips, and Procter & Gamble. As the old saying goes, imitation is the sincerest form of flattery.

But the real kicker is that in the case of IBM, Robo-Buffett beat the real Buffett to the punch. IBM has been a top holding of the ETF for as long as I've owned it. (IBM has, after all, increased its dividend for the past 16 consecutive years.) And IBM stock has performed fantastically over the past couple of years, something that Berkshire totally missed out on.

Why it's a core holding
Some of you may be wondering why this is called a dividend ETF when the yield is a pitiful 2.3%, pretty much equal to the S&P 500. After all, why buy a dividend ETF if not for a juicy yield, especially when there are higher-yielding alternatives? SPDR S&P Dividend (NYS: SDY) boasts a dividend yield over 3%, and iShares DJ Select Dividend (NYS: DVY) weighs in near 3.5%.

The answer, as I've written about many times, is that you should never buy an ETF or stock for its dividend yield. You should buy an ETF or stock for its risk and total return characteristics.

The problem with Vanguard Dividend Appreciation's higher-yielding brethren is they tend to overweight certain sectors, such as financials and utilities. By contrast, the Vanguard ETF's high-quality Buffett-like strategy has a history of rewarding shareholders without undue risk or sector concentration. Over the past 10 years, the index it's based on has beaten the S&P 500 by almost a percentage point per year -- with less volatility to boot.

And there's a special reason to believe that the Vanguard ETF may be particularly rewarding right now. Overall, the fund's holdings are trading at 14 times last year's earnings, which is actually lower than the broader market despite the stocks in the ETF portfolio having superior returns on equity.

That P/E of 14 corresponds to an earnings yield (earnings/price) of about 7%. So assuming earnings just grow with inflation -- which seems more than reasonable given the diversity and quality of the companies in the portfolio -- that's about equivalent to doubling your purchasing power every 10 years.

So I would reasonably expect a $10,000 investment in this ETF today, with dividends reinvested, to purchase about $160,000 worth of goods in 40 years time. Expected returns are even higher if these companies grow their earnings faster than inflation!

Of course, like any other investment in stocks, Vanguard Dividend Appreciation isn't a sure thing. Companies can change their dividend policies, but that's fairly rare among the companies that qualify for the index this ETF tracks. But unless corporate America starts to see paying a steadily increasing dividend as a way to game the system, this ETF should remain a great long-term investment.

The bottom line
It can take an investor awhile to create a portfolio of Buffett-like companies through picking individual stocks. So as I see it, why not let the Vanguard Dividend Appreciation ETF do the heavy lifting for you? After all, in investing, there are no special points for difficulty.

At the time thisarticle was published Fool contributor Chris Baines is a value investor. Follow him on Twitter, where he goes by @askchrisbaines. Chris' stock picks and pans have outperformed 92% of players on CAPS. He owns shares of Berkshire Hathaway and Vanguard Dividend Appreciation. The Motley Fool owns shares of Berkshire Hathaway, IBM, Wal-Mart, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway, Coca-Cola, Wal-Mart, and Procter & Gamble, as well as creating a diagonal call position in Wal-Mart. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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