What are we looking for?
Undervalued U.S. dividend growth stocks.
Quality dividend stocks have consistently been a great hiding place in bouts of volatility as investors seek steady income streams to offset inflation and rising rates. Yet dividend stock valuations largely reflect their popularity in the current environment, which makes it more difficult to purchase these names at a fair price.
Today I used Morningstar CPMS to search for undervalued U.S. dividend growers that have been consistently providing income to investors. Overall rankings were determined using the following criteria.
We begin our process by ranking the almost 2,000 U.S. stocks in our universe, weighting eight factors that total 100 per cent.
First, we placed a 36-per-cent weight on expected dividend yield above 3.5 per cent, in line with the U.S. 10 Year Treasury rate. The S&P 500 currently has a yield of 1.8 per cent.
Next, we weighted the five-year dividend growth rate and the five-year earnings growth rate at 18.5 per cent each. The dividend growth rate needed to be positive over this period because we want companies that have a track record of increasing their payout.
We then ranked stocks using analyst estimate revisions and the latest cash-flow-to-debt ratio, each factor with a weight of 9 per cent. Importance was placed on companies where analyst estimate revisions are higher than minus 2.2 per cent (the median value for estimate revisions in the U.S. universe over the past three months; a negative figure means estimates have been revised downward). Cash-flow-to-debt tells us how well the company’s operating cash flow is covering long-term debt – the higher the figure, the better.
Our final three factors have a 3-per-cent weight each: price-to-trailing-cash-flow, price-to-trailing-earnings and the proprietary Morningstar estimated fair-value-to-current-price. The first two are traditional ratios; the final is the result of our discounted cash-flow valuation models and is our per-share estimate of a company’s intrinsic worth. We adjust our fair values for off-balance sheet liabilities or assets that a firm might have (for example, we deduct from a company’s fair value if it has issued a lot of stock options or has an underfunded pension plan). A value of 1.0 means the company is fairly valued; a value of 1.5 means the company is undervalued – at a discount of 50 per cent. We are screening for companies with a score of 1.0 or greater.
In addition to our ranking criteria, we will buy stocks that are in the top 30 per cent of our universe and employ the following screens:
- Average daily total-dollar-value traded over the past three months more than US$36-million;
- Expected payout ratio below 70 per cent. This is the amount of dividends estimated to be paid in the next 12 months in relation to estimated earnings per share in the current fiscal year.
What we found
The strategy has been back-tested from December, 2006, to October, 2022, assuming an equally weighted 10-stock portfolio. On a monthly basis, stocks were sold if they fell below the top 45 per cent in our ranking. Stocks were also sold if the expected dividend yield fell below 2.5 per cent, or if analyst earnings estimates were revised downward by minus 11 per cent or lower, or the expected payout ratio went above 90 per cent. On this basis, the strategy produced an annualized total return of 11.7 per cent, while the S&P 500 Total Return Index advanced 8.7 per cent.
Stocks qualifying for this model are listed in the accompanying table.
This article does not constitute financial advice. Investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Joshua Farruggio is vice-president of business development at Morningstar Canada.