What are we looking for?
Companies with a sustainable dividend that are financially healthy.
Today I use Morningstar CPMS to look for Canadian dividend-paying companies with a sustainable payout ratio that are in a strong financial position. To be included on the shortlist, the stocks need to have paid a dividend for the past four years and they need to have maintained a minimum yield with relatively solid earnings expectations from the Street.
We want good diversification, so we’ve placed a limit of five stocks a sector except for financials, where the limit is 10. The financial sector has a higher limit in order to be more aligned to the S&P/TSX Composite Dividend Total Return Index. Ideally, we would like to identify companies with really good financial performance that are able to finance the dividend yield internally, so we’ve limited the payout ratio to 70 per cent or less. We don’t want companies that rely on debt or equity to finance the dividend because they will not be able to do so indefinitely.
The fundamentals of the business should dictate its ability to pay a sustainable dividend in the future. We apply a proprietary Morningstar quantitative financial health score to make sure that we are identifying companies with strong balance sheets in terms of financial performance, solvency and liquidity. Companies will be ranked higher when they have a lower payout ratio and higher dividend yield, expected dividend growth rate and financial health rating.
First, we selected our universe of stocks, which includes all 700 Canadian stocks in our CPMS database. We ranked our stocks from one to 700 according the dividend yield, payout ratio, expected one-year dividend growth rate and financial health.
Next, we applied four screens to create our list of stocks:
- Market capitalization above $500-million;
- Morningstar quantitative financial health score of 0.7 or greater (highest possible rating is 1.0);
- An annual dividend of at least 1 cent in each of the past four years. This is to eliminate companies that recently initiated a dividend.
- Estimate revisions higher than minus 5 per cent. (For this screen, it is okay for analysts to have a downward revision on earnings as long as it is not one of the worst 200 in the 700 in the CPMS universe.)
What we found
I used CPMS to back-test the strategy from January, 2006, to March, 2021. During this process, a maximum of 20 stocks in Canada were purchased and equally weighted. Stocks would be sold if their overall rank dropped out of the top half of our list. The portfolio is rebalanced monthly and the strategy produced a respectable annualized total return of 11.6 per cent since inception whereas the S&P/TSX Composite Dividend Total Return Index advanced 6.2 per cent on the same basis. The top 20 stocks that currently qualify for purchase into the strategy are listed in the accompanying table. They have an average yield of 2.8 per cent.
As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Phil Dabo, MFin, is a vice-president of business development at Morningstar Research Inc.
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