What are we looking for?
Sustainable dividend yields that may be hidden among Canadian mid-cap stocks.
As of Wednesday, four large Canadian banks have managed to beat earnings expectations in their most recent quarterly reports. This is great news for Canadian investors, many of whom hold substantial positions in our financial institutions, either directly and indirectly through a mutual fund or exchange-traded fund. Investors largely favour banks for their steady and consistent returns coupled with consistent dividends.
That said, dividend seekers may be missing opportunities if they’re only focusing on the larger end of the size scale. Today, I look for companies that pay reasonably sustainable dividends but which may be flying under your radar because of their smaller size. To find these companies I sorted the 708 stocks in the Morningstar CPMS Canadian database on the following factors:
- Five-year earnings and return on equity deviation (recall that deviation is a measure of volatility – here we prefer lower figures to find companies that have consistent earnings and return on equity);
- dividend yield.
I also screened for companies with a market float between $100-million and $1-billion, meant to exclude the bottom one-third and top one-half of the universe by size. Remember that market float is the total dollar value of a company that is available to be traded publicly. Also, to ensure reasonably sustainable dividends, I screened for companies that exhibited a payout ratio against earnings and cash flows of less than 80 per cent and 60 per cent, respectively.
More about Morningstar
Morningstar Research Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. Morningstar offers an extensive line of products and services for individual investors, financial advisers, asset managers, retirement plan providers and sponsors, and institutional investors. Morningstar Direct is the firm’s multi-asset analysis platform built for asset management and financial services professionals. Morningstar Canada on Twitter: @MorningstarCDN.
What we found
I used Morningstar CPMS to back-test the strategy from January, 2000, to July, 2021, assuming a 15-stock portfolio that never holds more than four stocks per economic sector. Once a month, stocks were sold if they fell below the top 35 per cent of the universe based on the aforementioned metrics, or if the payout ratios exceeded the stated limits.
When sold, stocks were replaced with next qualifying stock not already held in the portfolio, keeping in mind the sector limits. To account for the less liquid nature of mid- and small-cap Canadian stocks, I included a liquidity cost of 2 per cent for each transaction. This implies that stocks were sold at 2 per cent lower and purchased for 2 per cent higher than the closing price at the end of each month. On this basis, the strategy produced an annualized total return of 13.6 per cent, while the S&P/TSX SmallCap Total Return Index produced 5.3 per cent.
The stocks that meet requirements to be purchased into the strategy today are listed in the table. This article does not constitute financial advice. It is always recommended to speak with a financial adviser or professional before investing.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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