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Phil Dabo: Welcome to Quant Concepts working from home edition. Investing in dividend paying stocks can be a great way to add some income to your portfolio, as well as some diversification if you're more invested in growth-oriented stocks. There's also evidence to show that companies that have consistently grown their dividend over time tend to outperform the broader index. This makes a lot of sense because as companies become larger, they also become better at scaling their resources and eventually they have more income to distribute to shareholders. This process can also act as a reward for investors that have committed to the business.
Today, let's take a look at a strategy that focuses on Canadian stocks that have consistently grown their dividend over time. As always, we're going to start by ranking our universe of stocks, which includes all 700 stocks in our Canadian database. Next, we're going to rank our stocks according to four key factors.
The first factor is our expected dividend growth rate, which is a forecast of dividends for the next 12 months. The next factor is our expected payout ratio over the next 12 months. We would like to see companies with a good dividend growth rate. But we also want to make sure that they are not paying out too much of their income in dividends, so that they can still reinvest in their business for future growth. The next factors are Morningstar quantitative health score. This is a proprietary factor that we created to make it easier to determine whether a company is in good financial health. Our last factor is the company's yield. Although we're really focused on dividend growth, we still want to make sure that they have a minimum income distribution.
Now that we have our stocks ranked from 1 to 700, we're going to apply our buy and sell rules. We're only going to buy stocks that are ranked in the top 30th percentile. And we want our Morningstar quantitative health score to rank in the top third of our list. We want a minimum yield of at least 0.5%. And we don't want to buy companies that have a market cap of less than $500 million. The next four factors all have to do with the dividends that have actually been paid. We want to make sure that the company has actually paid a dividend in each of the last four years. And we also want their expected dividend for the next 12 months to be positive.
Lastly, we have our three-month earnings revision because we want to eliminate companies that rank in the bottom third of our list based on analyst expectations for earnings per share. Essentially, we want companies that analysts have a positive view on.
Now let's take a look at our sell rules which are very simple. We're going to sell stocks if they deteriorate and fall to the bottom half of our list. We're also going to sell stocks if their financial health deteriorates and falls to the bottom third of our list, and if analysts start to have a negative view on earnings per share.
Now let's take a look at performance. The benchmark that we use is the S&P/TSX Dividend Total Return Index, and we tested the strategy from January 2006 to May 2021. Over this time period, this strategy generated a very strong 11.9% return, which is 5.2% higher than the benchmark (indiscernible) 29% annualised turnover. We can see that this strategy has performed better than the benchmark over every significant time period. And it's even done so with lower price risk as you can see by the standard deviation. It's not surprising when looking at the standard deviation, that this strategy has had higher risk adjusted returns as you can see by the Sharpe ratio, and even has lower market risk as you can see by beta.
We can also see by looking at the performance chart that this is a strategy that has done very well over time. And when looking at the up and downside capture ratios, we can see that this strategy has performed well in down markets and still contributed very nice during up markets. The overall market capture ratio is quite strong, showing that this is a strategy that has performed well throughout different market cycles. This is a great strategy to consider if you're interested in companies that have strong financial performance and have the ability to grow their dividend over time.
Many investors may like this strategy because they would prefer to have a source of stable income instead of having to rely on capital gains. At the same time, these companies aren't paying out an excessive amount of income relative to the earnings that they generate. So they can still reinvest in their business to generate future growth.
Although the companies on the buy list don't necessarily have a high yield, they have proven their ability to grow their dividend over time. You can find the buy list along with the transcript of this video. From Morningstar I'm Phil Dabo.
