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Phil Dabo: Welcome to Quant Concepts' working from home edition. We saw many of the American indices perform well last year with the NASDAQ and S&P 500 up double digits. We also saw some of the less well-known small and mid-cap indices up double digits as well. However, stocks that pay a higher dividend did not do as well last year as we saw our Morningstar Dividend Leaders Index down 3.9% compared to the S&P 500, which was up around 18%. Some dividend-paying stocks can actually provide investors with really good downside protection and the additional benefit of receiving cash on a periodic basis.
Today, let's take a look at a strategy that focuses on companies with a sustainable dividend and a lower risk profile.
As always, we're going to start by selecting our universe of stocks, and today that's the S&P 500. We're going to rank our stocks from 1 to 500 according to six key factors. The first factor is beta because we want stocks that have lower risk than the market. Our second factor is the annual cash flow momentum because we want companies that have a strong ability to generate cash that they can use to pay dividends. The next three factors are the annual dividend momentum, the three-year normal dividend growth and the five-year normal dividend growth. This will help us find companies that have a strong history of paying dividends.
Now, let's take a look at our buy rules. We're only going to buy stocks that are in the top 35th percentile of our list. We don't want stocks that have a negative dividend momentum. I don't want stocks that have negative three or five-year normal dividend growth, and I don't want stocks that are expected to cut their dividend. I want companies that have a yield of at least 2% and I want to limit the amount of small-cap stocks in the portfolio. So, I've limited the market capitalization to no less than $1 billion. I don't want companies that have a payout ratio greater than 60% because I still want them to reinvest their earnings into profitable growth opportunities. The last buy screen is the Morningstar economic moat. This is a proprietary factor that focuses on companies that have a sustainable competitive advantage. Companies with a strong economic moat are able to generate strong profits over time.
Now, let's take a look at our sell rules. Our sell rules are very simple. We're going to sell companies that fall out of the top 50th percentile of our list. We are also going to sell stocks if the yield falls to below 1%. And we're also going to sell stocks if they start paying out more than 80% of their earnings in dividends.
Now, let's take a look at performance. The benchmark that we've used is the Morningstar Dividend Leaders Total Return Index, and we tested the strategy from January 2006 to December 2020. Over this time period, the strategy has generated a very strong annualized return of 12.8%, which is 5.5% higher than the benchmark and only 22% annualized turnover. This strategy has beaten the index over every significant time period, especially over the past year where it generated a return of 23.4% versus the benchmark of negative 3.9%. It's done so with slightly lower market risk as measured by beta and slightly lower price risk as measured by the standard deviation. This has contributed to higher risk-adjusted returns as measured by the Sharpe Ratio. And when looking at this graph, we can see that this strategy has performed very well since inception, and we can see by the market capture ratios that this strategy has a very good downside capture, which is great for conservative investors.
This is a great strategy to consider if you're looking for companies that pay a dividend and can provide good downside protection. It's suitable for conservative investors because it has provided very good returns by investing in larger companies with a sustainable competitive advantage that pay a nice dividend. The companies on the buy list have an average yield of 3%, which is 1.5 times more than the S&P 500. You can find the buy list along with the transcript of this video.
From Morningstar, I'm Phil Dabo.
For a larger image of the buy list, click here.
