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Ryan Strong: Welcome to Quant Concepts. This week, we’ll look at a simple Canadian dividend strategy that has returned 10% per year for the past 20 years. There are many advantages to owning Canadian dividend-paying stocks, such as tax-efficient income and stable price appreciation.
Today, we’re going to find the best companies in Canada that have consistently increased their dividends over the past three years. Our goal is to find medium to large sized companies that pay a consistent and meaningful return. We will look at factors such as dividend growth, payout ratio and earnings per share growth. Dividend growth will be the main factor we look for to ensure that investors in this strategy get an increase in income each year. The payout ratio is essential to ensure that companies still have income after paying dividends to reinvest in the business while being able to sustain the dividend over the long term. And finally, EPS growth is also a key factor in finding companies that increase earnings over time, leading to significant price appreciation.
First, let’s start by classifying and identifying our universe. We have identified all stocks with the full dataset in the Morningstar CPMS Universe. In the ranking step, we will include one main factor – the normalized 5-year dividend growth. Our screen will then only include stocks with rising dividends and rank them from highest to lowest. For this strategy we keep the screen extremely simple and then we will apply our buy rules.
The first buy rules will ensure that all companies bought into the model have increased their dividend for at least the last three years. This is accomplished with DIVG1, DIVG2, DIVG3, ensuring that all companies have dividend growth over the past three years. Next, we incorporate a market capitalization greater than $1 billion. This is an important rule to ensure that all businesses are large enough and have enough cash to move in and out. Yield is included over 1.5 to ensure that all companies purchased in the model have a meaningful dividend yield. Next, the payout ratio is included to only include stocks with a payout ratio below 70%, which is consistent with many of our predefined strategies at Morningstar CPMS. And finally, the 3-year normalized EPS growth is set at the industry median and will only include stocks in the top half of earnings per share growth.
Now let’s look at the sell side. We have identified three sell rules that will trigger our take profit strategy once a holding no longer meets any of these rules. First, we will sell a stake if the 5-year normalized dividend growth turns negative. Dividend growth is a key element of this strategy. We therefore wish to sell any name that no longer meets this requirement. Second, we will sell stocks if they no longer pay a dividend. As we are looking for yield, a stock without a dividend no longer meets our objectives. And finally, if the payout ratio exceeds 100, it is a good indication that the dividend is not sustainable and gives us a signal to exit our position.
Now that we’re done creating our strategy, let’s look at the back test page. In our back test, we started the simulation from January 2002 to January 2022, giving us 20 years of history. And over that period, we saw significant relative outperformance with a 10% annualized return. This was achievable with just 12% annualized revenue or about 2 stocks for a 20 stock portfolio.
Next, we’ll move on to attribution. The first notable factor is market capitalization. This strategy involves holding companies that are smaller than the underlying index, currently at an average of $20 billion versus the TSX at $64 billion. Holdings also have a much lower valuation than the TSX, such as 12 times price to earnings for our strategy versus 15.2 times price to earnings for the TSX, or 1.2 times sells for our strategy versus 2.1 times sales for the TSX. And finally, the growth and momentum characteristics tend to be in line with the TSX, while having slightly less quarterly earnings and sales momentum, but higher analyst recommendations overall.
In conclusion, this strategy is best suited for investors looking for high quality companies with predictable and stable dividends. Incorporating earnings growth allows us to outperform the index while achieving our goal of finding companies with increasing dividends.
From Morningstar, I’m Ryan Strong.
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