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Phil Dabo: Welcome to Quant Concepts working from home edition. Now that 2020 has finally passed, we can take a look at the calendar year return. It was a year full of ups and downs with markets plummeting in March and some indices recovering faster than others. The S&P/TSX Dividend Index is a perfect example of that. The index was only up 1% last year, whereas the broader S&P/TSX was up 5%. Today, let's take a look at a strategy that has beaten the index and focuses on lower volatility dividend growing stocks.
As always, we're going to start by ranking our universe of stocks. In this case, I'm using the CPMS 250, which excludes REITs because their payout ratios are typically high. Next, we're going to rank our stocks from 1 to 250. According to six key factors, the first two factors are the five-year dividend growth rate and expected dividend growth rate next year. The next factor is the annual cash flow momentum. Together, these three factors will look for stocks that have a good historic and expected dividend growth rate as well as cash flow to support those dividend payouts. Next, we want to include good downside protection by incorporating data and standard deviation. Together, this will reduce market risk and price risk. Our last factor is yield. Although this isn't one of our top factors, we still want to have a higher dividend yield.
Now let's take a look at our buy screens. We're only going to buy stocks that are ranked in the top 20th percentile of our list. We only want to buy stocks that have an expected dividend growth rate above zero, and a five-year dividend growth rate above 2%. We want stocks that have an ROE above 8%. Because we want good growth characteristics. We only want to buy stocks that have a market cap above $900 million, and we don't want to pay out too much of those earnings in cash flow and dividends. The last factor is our Morningstar financial health score. This is a proprietary measure indicating a company's financial health based on the firm's leverage. A higher score indicates lower leverage and less likelihood the company will fall into financial distress. This is very important right now given the state of the economy.
Now let's take a look at our sell rules. We're going to sell stocks that fall out of the top 30th percentile of our list. Again, we don't want a company with an expected dividend growth rate of less than zero. We're going to sell stocks that start paying out too much of their dividends in relation to cash flow and in relation to earnings. We're going to sell stocks if their financial health deteriorates and falls out of the top two-thirds of our list based on the financial health score.
Now let's take a look at performance. The benchmark that we use is the S&P/TSX Dividend Total Return Index, and we ran the strategy from January 2006 to December 2020. Over this time period, the strategy has returned 10.7% which is 5% more than the benchmark with only 27% annualized turnover. This is a strategy that has significantly outperformed over every significant time period. And it's done so with lower price risk as measured by the standard deviation. This has contributed to superior risk adjusted returns as measured by the Sharpe ratio. And also you will notice lower beta which measures lower price market risk.
You can see from this chart that this is a strategy that has outperformed over time. And when looking at the market capture ratios as is expected with a lower volatility dividend strategy. It has really good downside capture metrics, with decent upside capture, which means that this is a strategy that has outperformed over different market cycles.
Although this strategy doesn't necessarily have a high yield, it does have really good performance from dividend-paying stocks. This is a great strategy to consider if you're looking for stocks that pay a dividend and have a history of consistently growing their dividends over time. In addition to that, the buy list has 24 stocks with an overall yield of 2.8% which is only 0.2% less than the S&P/TSX. You can find the buy list along with the transcript of this video.
From Morningstar, I'm Phil Dabo.
For a higher resolution image of the buy list, click here.
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