What are we looking for?
Canadian dividend growth stocks that may be undervalued compared with their industry peers.
Investors are reminded that when looking at valuation metrics (such as price-to-earnings ratio), it is often useful not only to consider the measure against the stock’s own history, but also against peers in the same sector. To this end, today I use Morningstar CPMS to look for Canadian-listed companies that are trading at lower valuation metrics relative to their sectors by ranking the 709 companies in the CPMS Canadian database by:
- Expected dividend growth rate (comparing the dividends announced but not yet paid against trailing dividends);
- Sector-relative P/E, price-to-book and price-to-cash-flow ratios (here, we take the multiple for the company and compare it against the median of the sector to which the company belongs. For example, in the table, an industry relative P/E of 0.7 implies the company’s P/E ratio is 30 per cent lower than that of the sector, lower figures preferred).
Only companies with a market capitalization and dividend yield greater than the bottom one-third of the universe were considered (today, these figures are $180-milllion and 1.5 per cent, respectively). As a check to see that dividends are sustainable, I set a screen to ensure at least one of the following applied: that the dividend payout ratio on earnings was less than 80 per cent, or that the payout ratio on cash flow was less than 60 per cent. Finally, to ensure companies were profitable, I only considered companies with positive five-year average return on equity.
What we found
I used Morningstar CPMS to backtest this strategy from September, 1997, to February, 2021, using a maximum of 15 stocks with no more than three for every economic sector. On the last day of each calendar month, stocks were sold if they fell below the top 25 per cent of the CPMS universe based on the aforementioned metrics, or if a stock’s dividend payout ratio on earnings and cash flow exceeded 90 per cent and 70 per cent, respectively. When sold, they were replaced with the highest ranked qualifying stock not already held in the portfolio.
Additionally, to account for potential concern of smaller names that qualify, a 2-per-cent liquidity cost was included, implying that stocks were sold for 2 per cent less than the closing price on the last day of the month and purchased for 2 per cent more. On this basis, the strategy produced an annualized total return of 14.9 per cent, while the S&P/TSX Composite Total Return Index advanced 6.7 per cent. The stocks that meet the requirements to be purchased today are listed in the accompanying table. This article does not constitute financial advice. It is always recommended to speak with a financial adviser or professional before investing.
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.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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