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Emily Halverson-Duncan: Welcome to Quant Concepts. Socially responsible investing is often thought of as a separate investment style, like value investing or momentum investing. In practice however, investors need not choose between their ethical beliefs and their investment objectives. ESG screens, recall ESG stands for environmental, social and governance can be added to any style of investing allowing people to meet their investment goals while still retaining control of the ethical standards of companies they invest in.
With dividend stocks being such a popular choice of investment. Today, I've created a strategy which looks for Canadian dividend stocks suitable for socially responsible investors. So, let's take a look at how to build that.
First off with our model, we're going to go through and rank the universe of stocks. Our universe here is all the Canadian stocks in the CPMS database, which is just over 700 stocks. How we're going to rank the stocks? First off, we're going to rank stocks by their five-year dividend growth. So, we're looking for a larger dividend growth rate across that time frame. A high ESG score. So, what that looks at is on a percentage scale, so zero to 100. The higher the percentage the more ESG friendly that company is. We're going to look at annual dividend momentum. So is the company growing their dividends across the last year. And then lastly, a bit of a momentum indicator quarterly earnings surprise. So that's looking at whether or not a company was outperforming on what you expected their earnings to be.
From there, once we've ranked our universe of stocks, we're going to screen out the stocks that we don't want to own. Some of the screens that we'll apply here, expected dividend yield greater than or equal to a very specific 2.38%. You notice that's beside a C minus there. What that indicates is we want the dividend yield in the top half of peers. A few other screens we've got. We want the overall ESG score to be greater than this is the top third of the peers line or 57%. Highest controversy level, what that looks at is how controversial or how many controversial issues that are surrounding a company and how impactful that is. So, in this case, it scales from 1 to 5, 5 being the most severe, zero being the least. So, we want it to be less than or equal to a 3 so that we're on the less severe side.
On the sell indicators, we will sell a stock if their five-year dividend growth declines below zero. If their overall ESG score falls below the bottom half of peers, or if their highest controversy level rises above a 3. Some of the companies we'll see here that screen through Enbridge is actually the current highest-ranking stock that screens through those different screens. Atco and Finning International. Let's go ahead and run a back test to see how that model did over the long time frame. So here we're going to run a back test from October 2012 until end of September 2019 and we're going to have 10 stocks in the portfolio. So, let's take a look at how it does.
Alright, so the model performed quite well actually, compared to benchmark. 12% annualized return, which is an outperformance of 4.4%, relative to the benchmark, which in this case is the S&P/TSX. Turnover is very low at 8%. Again, what turnover looks at is how often you're going to be trading stocks out of the portfolio. So roughly of those 10 stocks you are going to be trading around 8% of them within a year. So not very many trades. Few of the metrics that I like to look at Sharpe ratio, which is a measure of risk adjusted performance, is at 1.2. Typically anything 1 or above is considered to be strong. A few other things downside deviation, which looks at the volatility of negative returns is 5.1 for the strategy versus the benchmark at 5.2. So pretty similar, slightly lower, which is a good indicator for risk.
So, this is an example here of how you can apply ESG screens on something that you're already looking for like income and still get a strategy that works well over the long term.
For Morningstar, I'm Emily Halverson-Duncan.
