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Joshua Farruggio: Welcome to Quant Concepts' working from home edition. Geopolitical tensions and inflationary pressures have investors focusing on downside risk. One way to ensure safety in portfolios is to add quality dividend-paying stocks. Investors can also manage volatility by looking at risk from an ESG lens. Environmental, social, and governance factors have been implemented in numerous investment strategies as the economy moves toward a more sustainable future. Investors now have the ability to align their values with their investments and remove ESG risks that can damage an investment portfolio.
Today, we'll focus on the Canadian landscape and look at a strategy that identifies sustainable leaders who are financially stable and have a proven track record of dividend payments.
Let's start by selecting our universe of stocks, which includes all 700 companies in our Canadian database. Next, we are going to rank our stocks from 1 to 700 using four key factors. The first factor is our expected dividend growth, measuring the difference between the expected annual dividend rate and the actual trailing dividend paid in the last four quarters. The second factor is our expected payout. This is the dollar amount of dividends estimated to be paid in the next 12 months, expressed as a percentage of EPS. This ratio is important to see how much earnings a company is expected to pay out in the form of dividends. Our third factor is our Morningstar quantitative financial health score to measure companies on the likelihood that they will tumble into financial distress. And finally, we'll have a 40% weight on the expected dividend yield.
Now that we have our 700 stocks ranked, let's apply our buy rules. We are going to buy stocks that are ranked in the top 30th percentile of our list. We will filter stocks that have less than 70% of their earnings being paid in the form of dividends. Next, we'll look at our Morningstar quantitative financial health score and search for companies that rank in the top third for this variable. We are also going to purchase companies that have an expected yield greater or equal to 1%. Followed by that, we want to ensure stocks in our portfolio have a consistent history of paying dividends. We'll be looking for companies that have a paid dividend in the last four quarters this year and the respective three years prior.
In addition, we'll apply the ESG risk rating, which measures the company's exposure and management of material ESG issues. This rating is based on a two-dimensional materiality framework that measures a company's exposure to industry-specific material risks and how well a company is managing those risks. Companies that score 30 or lower present medium, low, or almost no ESG risk. Whereas companies that score above 30 present high or severe ESG risk. Finally, we'll be looking at our quarterly earnings momentum, which measures the rate of change of quarterly operating earnings per share. We want stocks to be positive for this variable.
Next, we'll take a look at our sell rules. We are going to sell stocks if they fall out of the top 50th percentile of our list. We will also sell stocks when 90% of a company's earnings is being paid in the form of dividends. This is to ensure our company is also investing back into its business to sustain their dividend. If a stock's quant financial health score falls below 0.54, we will also sell. And finally, if a company has a high or severe ESG risk rating, it will be kicked from the model.
Let's look at performance. The benchmark that we used is the TSX Composite Dividend Total Return, and we tested this strategy from January 2006 to January 2022. Over this time period, the strategy generated a return of 12.1%, which is 5% higher than the benchmark and only a 20% annualized turnover. We can see by looking at the annualized periods of this strategy, it has performed well versus the benchmark over every significant time period. We also have superior risk-adjusted returns with the Sharpe Ratio doubling the index and a beta of 0.8. The strategy also demonstrates lower price risk and strong downside deviation.
Looking at the green and blue charts below, the strategy has beat the TSX Dividend Total Return by 90% of the time in down markets while still capturing a slight upside. This is a great strategy to consider if you're looking for quality companies that pay a consistent dividend. This strategy also seeks ESG leaders that combat financially material ESG risks with tremendous downside protection to weather market volatility.
The model has outperformed the index 13 of the past 16 calendar years. You can find the buy list along with the transcript of this video.
From Morningstar, I'm Josh Farruggio.
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