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Phil Dabo: Welcome to Quant Concepts' working from home edition. It can be challenging to find yield when interest rates decline the way that they have over the past year. Many investors prefer to have investments that have a strong yield so that they can pay for their daily expenses. Many conservative investors prefer to have a return in the form of a distribution as a short-term reward on their investments. Likewise, many companies have excess cash that they can distribute to their shareholders instead of reinvesting in their businesses.
Today, let's take a look at a strategy that focuses on companies that have a higher dividend yield that can compensate investors that are looking for a consistent cash flow.
Now, let's take a look at our strategy. We're going to start by selecting our universe of stocks, which is all of the Canadian stocks in our database with the complete data set. We're going to rank those stocks from 1 to 700 according to seven key factors. The first factor is yield, because we're looking for higher income. The next factor is the interest coverage ratio, which measures how easily a company can pay interest on its outstanding debt. We would like to see companies that can easily pay for their debt obligations and still have a lot of money to distribute to shareholders at the same time. The next factor is our Morningstar quantitative financial health score, which is a proprietary variable that measures the likelihood that a company will fall into financial distress. The next two factors are the annual earnings momentum and the quarterly earnings momentum. Ideally, we'd like to see companies consistently increasing their earnings over time. The next factor is our quarterly earnings surprise, and ideally, we'd like to see companies that are consistently increasing their earnings over time and are also beating analyst expectations. Our last factor is the market cap of a company because we would like a strategy to have a bias toward larger cap companies.
Now, let's take a look at our buy rules. We're only going to buy companies that are in the top 30th percentile of our list. We're going to focus on companies that have a yield of at least 3.5%, which is almost 1% more than the S&P/TSX. We are only going to buy stocks that are in the top third of our list based on the Morningstar quantitative financial health score. We're going to try to eliminate micro-cap stocks by placing a minimum market cap of 500 million. Finally, we want companies that have less market risk measured by beta, so we're going to place a maximum beta restriction of 1.2.
Now, let's take a look at our sell rules, and their sell rules are very simple. We're going to sell stocks if they fall out of the top 50th percentile of our list, and we're also going to sell stocks if their financial health deteriorates and falls to the bottom third of our list based on the Morningstar quantitative financial health score.
Now, let's take a look at performance. The benchmark that we used is the S&P/TSX High Dividend Total Return Index and we tested this strategy from June 2012 to February 2021. Over this time period, this strategy generated a very good 11.3% return, which is 4.6% higher than the benchmark with only a 19% annualized turnover. We can see at the annualized returns that this is a strategy that has performed well over every significant time period. Even if it had market-like price risk as measured by the standard deviation, it still has higher risk-adjusted returns as measured by Sharpe Ratio and slightly higher market risk as measured by beta.
We can see by this graph that this is a strategy that has performed quite well over time, especially over the past year, even when it had a 5% yield. When looking at the market capture ratios, we can see that this is a strategy that has performed quite well in down markets.
This is a great strategy to consider for investors that are looking for a strategy that is less volatile than the index and if one of their primary objectives is to generate income. The additional benefit of this strategy is that it has performed very well over the past year, whereas the High Dividend Index has lagged the broader S&P/TSX. Furthermore, the companies on the buy list have a yield that ranges from 3.7% to 8%. The yield of the buy list is currently 5%, which is almost twice as much as the S&P/TSX. You can find the buy list along with the transcript of this video.
From Morningstar, I'm Phil Dabo.
Click here for a larger image of the buy list - Part 1
Click here for a larger image of the buy list - Part 2
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