What are we looking for?
Large U.S. companies paying out reasonable yields and showing steady earnings.
The screen
With a new U.S. President commencing what appears to be the execution of campaign promises, investors in the U.S. equity markets are reacting well so far, all things considered. Year to date, the S&P 500 total return index is up around 6 per cent. However, for those less confident in the growth of the U.S. economy, the following conservative, yield-focused strategy can offer some ideas. The strategy ranks stocks on three basic factors:
- Market capitalization (larger companies are preferred here);
- Expected dividend yield (dividends that the company has announced but have not yet paid);
- Consistency of historical earnings measured over a five-year period (here, we use a statistical measure called standard error as a measure of volatility around a five-year median figure – lower numbers preferred);
To qualify, companies must have a debt-to-equity ratio equal to or less than the median of the sector to which it belongs (to avoid overly leveraged companies). Additionally, stocks with dividend payout ratios greater than 80 per cent were screened out to ensure that we look for a sustainable yield. Lastly, for the Canadian audience, companies with a limited partnership structure were screened out (which have additional tax implications for Canadian investors).
More about Morningstar
Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used Morningstar CPMS to backtest this strategy from April, 2004, to January, 2017. During this process, a maximum of 15 stocks were purchased with a maximum of four stocks per economic sector. Stocks are sold if their rank falls below the top 25 per cent of the universe, or if the dividend payout ratio exceeded 100 per cent. When sold, the positions were replaced with the highest ranked stock not already owned in the portfolio.
Over this period, the strategy produced an annualized total return of 10 per cent while the S&P 500 total return index advanced 8.1 per cent. Since April, 2004, the strategy had an average annual turnover of about 4 per cent, meaning that many of the original stocks purchased in 2004 remain in the portfolio today. The 15 stocks that qualify for purchase into the strategy today are listed in the accompanying table.
As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.