What are we looking for?
Smaller Canadian companies with attractive dividends and lots of free cash flow.
While yield-hunting has become investors' favourite sport, many people focus on big dividend payers. Today, we'll see whether stocks with smaller market capitalizations might offer equally enticing payouts.
One of the key criteria we'll use is free cash flow, a measure of how much cash a company has left over after paying its operating bills and taking care of capital expenditures on things such as buildings and equipment.
Lots of free cash flow (FCF) increases the odds that a company will raise its dividends.
How we did it
Craig McGee, senior consultant at CPMS Morningstar Canada, started by looking for firms that are members of the S&P/TSX small cap index or BMO small cap index and that also have expected dividend yields of more than 2.5 per cent. He eliminated any that are paying out more than 75 per cent of their free cash flow as dividends.
He then searched for the ones with the best combination of:
- expected dividend yield;
- free cash flow yield;
- free cash flow payout ratio;
- free cash flow margin.
Free cash flow yield is FCF divided by share; free cash flow payout ratio is expected dividends divided by FCF; and free cash flow margin is FCF divided by sales.
More about Morningstar
Morningstar 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.
What we found
Mr. McGee used the CPMS backtest to select all stocks in the CPMS universe that were members of the S&P/TSX small cap index at the end of 2005. He then compared how they would have fared compared with stocks selected by the criteria above.
He found that the free cash flow strategy would have produced an annualized return of 7.1 per cent, compared with 2.6 per cent for small caps in general.
As always, you should do your own research before buying any of the stocks listed here.
Ian McGugan