Quant Concepts: Defensive Stocks with Consistent Dividends

This strategy from Josh Farruggio focuses on stocks with solid earnings growth, sustainable dividend payments and exceptional downside protection.

Joshua Farruggio 12 May, 2022 | 4:28AM
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Joshua Farruggio: Welcome to Quant Concepts. Monetary policy today faces a big challenge – tame inflation and maintain a strong economy. Geopolitical risks and economic headwinds pose the biggest threat to global growth. This has rattled equity markets as inflation reaches a four-decade high, prompting the Federal Reserve to begin raising interest rates.

The market is telling us it will be a difficult balancing act as investors fear the move could tip the economy into recession. Investors looking to remain in equities can look toward defensive companies that provide consistent dividends and stable earnings regardless of the state of the stock market. Defensive stocks offer long-term gains with lower risk and tend to outperform the broader market during recessions.

Today, we'll focus on the U.S. market and look at a strategy that focuses on companies that are in a strong financial position, have a sustainable yield, consistent earnings growth and low risk.

Let's start by selecting our universe of stocks, which includes all 2,000 companies in our U.S. database. Next, we are going to rank our stocks from 1 to 2,000 using five key factors. The first factor is the expected dividend yield, which is the estimated annual dividend rate expressed as a percentage of the latest market price. The next factor is our five-year normalized earnings growth. This will help identify sustainable companies as we look for the annual compound growth of earnings over the last five years. Our third factor is the standard deviation of our five-year normalized earnings growth to ensure less dispersion or variation.

After that, we are going to be looking at our quarterly earnings momentum relative to the industry group. This measures the rate of change of quarterly operating earnings and will help us understand if a company is increasing their trailing earnings in the past quarter to improve bottom-line growth. Our final 20% weight will be allocated to cash flow to debt. This will help put emphasis on companies that are positioned well to repay their debts.

Now that we have our 2,000 stocks ranked, let's apply our buy rules. We are going to buy in the top 25th percentile of our list. We are also going to buy companies with an expected yield above 1.5%. We'll take a look at our five-year normalized EPS growth and look for companies with a median score. Next, we'll take a look at our quarterly earnings momentum versus the industry and look for a median score as well. We'll do the same with our cash flow to debt ratio.

Followed by that, we'll look at our five-year normalized dividend growth. This measures the annual compound growth of dividends per share, averaged over the past five years. We are looking for companies with a minimum 5% for this variable. To ensure a sustainable payout, we'll look for companies with positive annual dividend momentum and also an expected payout below 70%. This will help us determine how much earnings a company is expected to pay out in the form of dividends. And finally, we'll be filtering for companies with the beta below 1 and a market cap above 8.5 billion.

Next, we'll take a look at our sell rules. We are going to sell stocks if they deteriorate and fall out of the 45th percentile of our list. We'll also sell stocks if their yield falls below 0.5%. And we'll sell our quarterly EPS momentum and cash flow to debt ratios if both fall below a D minus. And finally, when 90% of a company's earnings is being paid in the form of dividends, we will sell. This is to ensure a company is also investing back into its business to sustain their dividend.

Let's look at performance. The benchmark that we use is the S&P 500 Total Return, and we tested this strategy from December 2006 to April 2022. Over this time period, the strategy generated 15.3% return, almost 6% higher than the benchmark, with an 18% annualized turnover. We can see by looking at the annualized periods for this strategy, it has performed well versus the benchmark over every significant time period. The strategy also demonstrates lower price risk, strong downside deviation, and we also have superior risk-adjusted returns with a Sharpe Ratio doubling the index and a beta of 0.9 displaying lower market risk. When we scroll down, we can see the S&P 500 has been beaten 93% of the time in down markets and 57% of the time in up markets.

We'll take a look at the performance breakdown tab and place particular focus on a few down years. In 2008, the S&P 500 was down 37%, and our strategy was down negative 20%, with a net return of 17% overall. If we focus on 2018, the market was down 4.5% and our strategy was up 4.5%. Looking at this year, the S&P 500 is down 13% and our strategy is down 4.9%, beating the market by 8% on a net basis.

This is a great strategy to consider if you're looking for well-established companies that have solid earnings growth and sustainable dividend payments. These companies can survive in a rising rate environment as they can pay down debt if liquidation were to occur. Defensive stocks present exceptional downside protection to weather the current volatile environment and have resilient business models. You can find the buy list along with the transcript of this video.

From Morningstar, I'm Josh Farruggio.

Find the buy list here.

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Joshua Farruggio  Vice President, Business Development, CPMS

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