What are we looking for?
U.S. companies with consistent dividend growth that are financially healthy.
The screen
I used Morningstar CPMS to look for U.S. companies that are financially strong and have consistently increased their dividend over the past five years. We have placed lower limits on the dividend growth rates over one to five years to make sure that the dividends are trending upward each year. We also apply a five-year normalized growth rate to make sure the five-year dividend growth rate is positive.
Essentially, we want to focus on companies with the highest five-year dividend growth rates that are also increasing their dividend every year. We also want companies with a minimum dividend yield of 1 per cent. The companies need to be able to finance this yield with strong operational performance, so we’ve placed an additional upper limit of 70 per cent on the dividend payout ratio. This will make sure we find companies that aren’t financing their dividends externally with debt or equity.
In other words, they need to generate enough income internally to have a yield of at least 1 per cent and be able to increase that dividend over time. Ideally, we would like to see companies with a dividend yield that continues to increase along with their stock price.
Lastly, we apply a proprietary Morningstar Factor for Financial Health to make sure we are identifying companies with strong balance sheets in terms of financial performance, solvency and liquidity.
First, we selected our universe of stocks, which includes the largest dividend payers in the United States. We ranked our stocks from 1 to 900 according to the most important factor: the five-year normalized dividend growth rate.
Next, we applied six screens to create our list of stocks:
- Market capitalization greater than US$500-million
- Dividend yield greater than 1 per cent
- Morningstar Quantitative Health greater than 0.7
- Dividend payout ratio of less than 70 per cent
- Five-year normalized growth rate greater than 0.01 per cent
What we found
I used CPMS to back-test the strategy from December, 2009, to March, 2021. During this process, a maximum of 20 U.S. stocks were purchased and equally weighted. Stocks would be sold if their overall rank dropped out of the top half of our list. The portfolio was rebalanced monthly.
The portfolio produced a respectable return of 15.4 per cent since inception, while the Morningstar Dividend Leaders Index High Dividend Index returned 12.3 per cent. The top 20 stocks that qualify for purchase into the strategy today are listed in the accompanying table and they have an average yield of 2 per cent.
As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Phil Dabo, MFin, is a vice-president of business development at Morningstar Research Inc.
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Phil Dabo, MFin