What are we looking for?
U.S. consumer defensive stocks that pay dividends.
Despite the U.S.-China trade war and an inverted yield curve, the U.S. economy seems to be trucking along. Since the start of the year, U.S. GDP has increased and U.S. unemployment, after creeping up to 4 per cent in February, is now back at 3.7 per cent (very close to where it was in 2000 prior to the tech bubble).
In theory, an economy like this, coupled with low interest rates, suggests that the trajectory of U.S. consumer spending should remain steady, all else being equal. As the name implies, consumer defensive stocks (makers of food, beverages and household products) are often less volatile than consumer cyclical stocks (typically providing good and services tied to the economy such as automobiles, restaurants and residential construction).
For dividend investors wary of current market volatility, this week I look for companies in the U.S. consumer defensive sector (today consisting of 114 names in the CPMS U.S. database) that show a good combination of the following metrics:
- Dividend yield;
- Free cash flow yield (calculated as operating cash flow in excess of capital expenditures over enterprise value, higher figures preferred);
- Expected annual dividend growth rate (calculated from announced future dividends from the company but not yet paid);
- Return on equity.
To qualify, companies must have a market capitalization greater than US$1.3-billion (this figure is meant to exclude the bottom one-third in this sector by market cap). Additionally, to qualify, companies must have a dividend payout ratio against earnings and cash flows of less than 80 per cent and 60 per cent, respectively. These limits were used to ensure that dividends are sustainable.
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 February, 2007, to September, 2019. During this process, a maximum of 10 stocks were purchased and equally weighted. Once a month, stocks were sold if their rank fell below the top 25 per cent of the universe, if ROE turned negative, or if the dividend payouts breached the aforementioned limits. 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 15 per cent while the Morningstar U.S. Consumer Defensive Index rose 10 per cent on a total return basis.
The stocks that qualify for purchase today are listed in the table 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.
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