What are we looking for?
Undervalued U.S.-listed dividend-payers with competitive barriers to entry.
The performance of dividend investments during the pandemic is leaving something to be desired for conservative investors. Case in point, from Feb. 21 to March 23 (peak to valley), the S&P 500 Dividend Aristocrats Index slightly underperformed the more traditional S&P 500 (on a total return basis the indexes lost 35 per cent and 33 per cent, respectively). Seeking inspiration from Morningstar’s Wide Moat index, which outperformed both benchmarks during the drawdown in March, I use Morningstar CPMS to look for dividend-paying companies that also have a “narrow” or “wide” economic moat and appear undervalued.
More specifically, I ranked the 2,100 U.S.-listed stocks on the following factors:
- Dividend yield;
- Quarterly earnings momentum (measured as the latest four quarters of earnings compared with the same figure one quarter ago);
- Latest reported return on equity.
To qualify, companies must have an economic moat rating of narrow or wide. Recall that Morningstar’s economic moat ratings centre around a company’s ability to earn a return on capital higher than its cost of capital over the medium to long term, stemming from competitive barriers of entry. (As the name implies, a narrow moat stock would have a milder competitive advantage than its wide counterpart.)
In addition, companies must be rated four or five stars, signifying that they are trading below fair value according to Morningstar’s analyst team. To ensure dividends are reasonably sustainable, I look for a dividend payout ratio of less than 80 per cent on earnings, and less than 60 per cent on cash flows. Finally, I’ve only included companies that have announced they are maintaining or growing their dividends based on the most recent company report.
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.
What we found
I used Morningstar CPMS to back-test this strategy from April, 2004, to May, 2020, using a maximum of 15 stocks with no more than three per economic sector. Once a month stocks were sold if they dropped below the top 50 per cent of the universe based on the factors listed above, if their star rating dropped below three (three stars signifies that the stock is close to fair value), or if dividend payout ratios exceeded the above limits.
Over this period the strategy produced an annualized total return of 11.4 per cent while the S&P 500 advanced 8.7 per cent on the same basis. The stocks that meet the requirements to be purchased into the model today are listed in the accompanying table.
This article does not constitute financial advice. It is always recommended to speak to a financial adviser or professional before investing in any of the products shown here.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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