What are we looking for?
Looking beyond the index for dividend payers growing cash.
Last week, I outlined a strategy that catered toward those who were cautiously optimistic about the Canadian equity markets. In a similar frame of mind, this week I look for small- and mid-cap companies outside of the S&P/TSX Composite Index. Recall that typically in volatile markets, small-cap companies tend to move more quickly than their large-cap counterparts. This week’s strategy aims to temper this expected volatility by looking for the traditional defensive characteristics of dividend growers within the small-cap space in Canada. To find these companies, I rank stocks on:
- Expected dividend yield;
- Five-year cash flow growth rate;
- Standard deviation of total returns over the past 180 days (a measure of consistency of the stock’s price movement, lower figures preferred).
To qualify, companies must have a payout ratio on trailing earnings and cash flow less than 80 per cent and 60 per cent, respectively, to ensure reasonably sustainable dividends. Additionally, companies must not be part of the S&P/TSX Composite Index and must have a market float greater than $110-million. Recall that market float is the total dollar value of a company that is available to be traded publicly.
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 January, 2000, to the end of October, 2019. During this process, a maximum of 15 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 index, if their payout ratios on earnings or cash flow exceeded 90 per cent or 80 per cent, respectively, or if a company cut its dividend. Owing to the illiquid nature of many of these stocks, a 1-per-cent liquidity cost was applied over the back-test period (stocks were sold for 1 per cent lower than their close, and bought for 1 per cent higher).
Over this period, the strategy produced an annualized total return of 11.5 per cent while the S&P/TSX SmallCap Index produced 3.9 per cent on a total return basis. In calendar year 2018, the strategy lost 11 per cent while the index lost 18.2 per cent.
Only 10 stocks qualify for purchase today and they 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.
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