Quant Concepts: Uncommon Canadian dividend stocks

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Emily Halverson-Duncan: Welcome to Quant Concepts' virtual office edition. Dividends can be a great way to add stability to your investment portfolio. Companies that pay and maintain a dividend over the long-term tend to be more stable in nature and fluctuate less when markets are choppy. This is perhaps part of the reason why dividend-paying companies tend to be so popular amongst retail investors. While most investors tend to gravitate towards large dividend payers such as banks or utilities as there can be comfort and familiarity, there can still be opportunities amongst the lesser-known companies. Today, I'm building a strategy that's searching for Canadian dividend growth stocks outside of the S&P/TSX Composite to find companies with a stable dividend history that aren't as readily recognizable as their counterparts on the index. So, let's take a look at how to build that.

First off, we are going to rank our universe of stocks. Here note that the universe though is the Canadian stocks excluding the TSX. So, as of today, there are 465 names that meet that criterion. Of those 465 names, how we're going to order them? We're going to look at five-year annualized dividend growth. So, we want to see a higher number for that, meaning companies who have been growing their dividends over the long-term. Expected dividend growth looks at what the company is expected to pay out in dividends compared to what they just paid out in the trailing four quarters and again, we want to see a higher value for that. And then, lastly, five-year normalized cash flow growth which looks at operational cash flow. And again, we want to see a higher value for that.

Once we've organized our universe, we are going to go ahead and screen out the names we don't want to own. So, some of the screens that we are looking at – five-year normalized dividend growth, we want that to be in the top third of peers which today has a value of about 5.01% or higher. Payout ratio, which is how much of a company's earnings are being paid out in dividends. We are putting a cap on that at 80%. So, the reason for that cap is to make sure there's excess cash or excess earnings available to invest back in the company or invest into other growth projects. Expected dividend growth, we want to make sure that dividends are either staying flat or that they are growing. So, we set a minimum floor thereof zero. Five-year beta, which is another measure of stability and sensitivity, we want that to be less than or equal to 1, meaning that stocks are as sensitive or less sensitive than the market. And then, lastly, we want dividends paid in the last four quarters to of course be positive to make sure we are looking at companies that are actually paying a dividend.

On the sell side, once we have applied all those filters, we have two simple sell rules here. Expected dividend growth, if that's less than zero, meaning a company is cutting their dividends, we're going to remove that stock from the model. And then, that five-year beta, if that rises above 1.3, we're considering it as too sensitive now in comparison to the market and we're going to remove that from the model.

So, once all these rules are applied, we of course want to see how the model did in our backtest. So, let's go ahead and take a look. Our backtest today is going to be running 10 individual stocks, so no more than 10 names and the time period is from September 1997 until May 2020. One thing to note as well about the backtest – because we're dealing with some smaller names, we're looking outside of the TSX, we've applied a liquidity cost on top of the performance. So, what that means is, we've applied a liquidity cost of 1%. So, when I sell the stock, I'm going to be selling it at a price 1% lower than what I would have already, so taking a 1% loss or a 1% cut. And then, when I'm buying a stock, I'm going to be buying it at a 1% higher price, so again, I'm negatively impacting myself just to account for the fact that some of these names may be less liquid meaning that they may be a little harder to trade in and out of as easily as some bigger names. In terms of performance, the model returned 13% annualized across that timeframe which is an outperformance of 7% or almost double the benchmark which returned 6% across that time period. Benchmark here of course is the S&P/TSX Composite. Turnover is really low, 22%. So, on 10 stocks you're probably going to be placing about two, maybe three trades a year on average which obviously is not too many in the context of a full year.

Few of the metrics that we always like to look at – downside deviation, which is a measure of the volatility of negative returns for the strategy was 8.2% and for the benchmark was 10.8% indicating that there is less volatility and negative returns for the strategy. And then, of course, we like to look at my favourite green and blue chart which is right here. In up markets, the model outperformed 45% of the time compared to the benchmark and in down markets, it outperformed 81% of the time. So, similar to that downside deviation, we can see this model was quite strong in down markets. So, for yourself, if you are interested in income stocks, which is very common for Canadian investors, there are ways that you can look for stocks that aren't as commonly held by other investors by looking outside of the TSX and we can see they provide pretty good value.

For Morningstar, I'm Emily Halverson-Duncan.