What are we looking for?
S&P 500 companies paying reasonable dividends, with enough cash to pay them.
Based on last week’s release of minutes from the U.S. Federal Reserve’s most recent policy meeting, it seems the Fed is fairly confident in the U.S. economy and will continue raising rates, but is also cognizant of trade disputes that might take the economy off course. For those investors wary of possible economic disruption, today’s fairly conservative large cap income-focused strategy may offer a few defensive ideas. The strategy first looks at the stocks in the S&P 500 and ranks them based on:
- Dividend yield;
- Quarterly and annual cash flow momentum (last four quarters of operating cash flow compared with same figure one quarter and four quarters ago, higher figures preferred);
- Five-year variability of earnings (a statistical measure that shows how steady a company’s earnings have been over the last five years, lower figures preferred);
To qualify, companies must have a payout ratio on earnings less than 80 per cent, or a payout ratio on operating cash flow less than 60 per cent. (Note that, as long as one of these two payout ratios are below their respective limits, the stock still qualifies.) These figures imply that the company has not stretched itself too thin in order to pay a dividend. Companies must show positive earnings in their latest reported quarter (not shown) and have a dividend yield greater than 1.33 per cent (this figure removes the bottom one-third of stocks by yield in our 500-stock universe).
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 back test this strategy from January, 2005, to June, 2018. During this process, a maximum of 20 stocks were purchased and equally weighted with no more than four per economic sector. Once a month, stocks were sold if their rank fell below the top 35 per cent of the ranked universe or if the payout ratio on earnings breached 100 per cent and the payout ratio on cash flows breached 80 per cent, signalling that the company is no longer able to pay a sustainable yield. 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 11.7 per cent while the S&P 500 total return index rose 8.5 per cent. In calendar year 2008, the strategy lost 19.9 per cent while the S&P 500 lost 37 per cent. Of the 48 months in this 13-year period where the index showed negative returns, our strategy beat the index 80 per cent of the time with an average net return of 2.1 per cent better than the index.
The stocks that meet our requirements for purchase are listed in the accompanying table. It is always recommended to speak to a financial adviser or investment professional before investing.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.