What are we looking for?
Dividend growers outside of the S&P/TSX Composite Index.
While less stable than their bigger counterparts, and often overlooked because they are not part of the S&P/TSX, mid- and small-capitalization stocks have offered many opportunities for growth, and sometimes even income. This week, I use Morningstar CPMS to create a mid/small-cap equity portfolio that also focuses on growing dividends. To build this strategy, I rank stocks outside the S&P/TSX (today consisting of 463 companies in the CPMS Canadian database) according to the following metrics:
- Dividend yield;
- Five-year dividend growth rate (on average, how much dividends have grown each year over the past five years);
- Annual cash flow momentum (past four quarters of operating cash flow compared with the same figure four quarters ago);
- Trailing return on equity.
To qualify, companies must have a dividend payout ratio of less than 80 per cent of earnings or less than 50 per cent of cash flows. This ensures companies have a sustainable dividend.
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 120 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 September, 1997, to December, 2018. During this process, a maximum of 20 stocks were purchased and equally weighted with no more than five for each economic sector. Once a month, stocks were sold if their rank fell below the top 40 per cent of the ranked universe, or if consensus earnings-per-share estimates dropped by more than 10 per cent over three months. When sold, the positions were replaced with the highest ranked stock not already owned in the portfolio assuming a 1-per-cent liquidity cost (stocks were sold for 1 per cent lower than the close price and bought for 1 per cent higher to account for market movement in smaller, less liquid names). Over this period, the strategy produced an annualized total return of 11.6 per cent while the BMO Nesbitt Burns Small Cap Index gained 4.3 per cent on a total-return basis. This strategy was not immune to recent downturns though; in 2018, the strategy lost 15 per cent while the benchmark lost 20.1 per cent.
Today, only 11 stocks qualify for purchase and are shown in the chart below. 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.