What are we looking for?
U.S. consumer defensive stocks with sustainable dividends.
With bond yields remaining low and a fourth wave of COVID-19 in full swing in the United States, yield-hungry investors might consider looking to the consumer defensive sector (a.k.a. consumer staples) for some ideas. The concept has some merit. During times of duress, such as lockdowns, consumers still require basics (groceries, household products and alcohol), and this mature sector can offer consistent yields. To aid in this search, I looked to the Morningstar CPMS U.S. database, which houses 105 consumer defensive stocks. I ranked these stocks based on several factors::
- Dividend yield;
- Five-year average return on equity (ROE);
- Five-year deviation of ROE (a measure of how consistent a company’s profits are. Here, we prefer lower values);
- Five-year historical beta (this measures the historical sensitivity of a stock’s price movement against the index. A stock with a beta of one moves more or less in tandem with an index, while a stock with a beta less than one has historically moved less. Lower figures are again preferred);
- Five-year historical cash flow growth (on average, how much annual operating cash flow has grown over the past five years).
To ensure sustainable yields, I also placed a screen on the companies’ dividend payout ratios. To qualify, a company must have a payout ratio relative to earnings of less than 80 per cent, or a payout ratio relative to cash flow of less than 60 per cent. The idea here is to ensure a company does not pay out too high a proportion of its earnings or cash flow as a dividend, which over time is not sustainable.
What we found
I used Morningstar CPMS to backtest the strategy from April, 2004, to July, 2021, assuming a 10-stock portfolio consisting entirely of consumer defensive companies. Once a month, stocks were sold if they fell below the top 35 per cent of the universe based on the aforementioned metrics, or if the dividend payout ratio exceeded 100 per cent of earnings and 80 per cent of cash flow. When sold, stocks were replaced with next qualifying stock not already held in the portfolio.
On this basis, the strategy produced an annualized total return of 10.9 per cent, while the S&P 500 Consumer Staples Total Return Index produced 9.8 per cent. The stocks that meet the requirements to be purchased into the strategy today are listed in the 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 multiasset analysis platform built for asset management and financial services professionals. Morningstar Canada on Twitter.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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