What are we looking for?
A portfolio of Canadian dividend stocks with and without a stop-loss order.
The screen
With the novel coronavirus at the centre of almost every conversation and news report, it’s no wonder markets around the world have been volatile. Given the pain investors have already suffered, and the continuing uncertainty, they have to wonder how much further the declines will go.
I can’t say, but one question I can address is whether or not exiting your holdings during periods of market volatility has any benefit over the long term.
In today’s article, I’m testing whether to stick it out when your holdings are declining, or to cut your losses and run. Given the popularity of income investing, I’ve created a strategy that searches for companies with growing dividends, and I compare it with the same model with a price stop-loss order added as a sell criterion.
Recall that a stop-loss order refers to selling a stock once it declines past a threshold. For the purpose of this article, the stop loss will be set at a 10-per-cent price decline.
This strategy ranks stocks based on:
- Five-year dividend growth – annualized dividend growth over the past five years. High values are preferred;
- Expected dividend growth – a percentage change. The average change in the expected dividend over the next four quarters compared with the dividend paid the previous quarter. High values are preferred;
- Quarterly earnings surprise – a proprietary measure of the difference between actual and expected quarterly earnings. High values are preferred;
In order to qualify, stocks must have a five-year dividend growth rate in the top third of peers (today this value is greater than or equal to 9.47 per cent); positive expected dividend growth; a five-year standard deviation of returns in the bottom 50 per cent of peers (today this value is less than or equal to 46.5 per cent) in order to help manage swings in returns; a dividend payout ratio less than or equal to 75 per cent of earnings to ensure companies have excess profit for growth purposes; and five-year sales growth greater than or equal to 0.
More about Morningstar
Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers.
CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used Morningstar CPMS to back test this strategy from January, 2004, to February, 2020.
During this process, a maximum of 15 stocks were purchased. No more than five stocks in any economic sector could be held at any time.
Stocks were sold in the original model if their five-year dividend growth fell into the bottom third of peers or their dividend payout ratio climbed above 80 per cent.
In the stop-loss model, sell criteria also included a minus 10-per-cent stop loss over the preceding 30 days. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio.
Over the 16-year period, the strategy without the stop-loss order produced an average annualized total return of 12.3 per cent while the S&P/TSX Composite Total Return Index returned 7 per cent.
The same strategy with the stop loss returned 11.6 per cent.
It’s also worth noting that in 2008, the benchmark returned minus 33 per cent, the original model returned minus 25.88 per cent and the stop-loss model returned minus 33.62 per cent.
So, adding a stop loss in this test resulted in worse results during the 2008 credit crisis. Investors would have been better off staying the course.
Stocks that qualify for purchase into the strategy today are listed in the accompanying table. As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Emily Halverson-Duncan, CFA, is a Director, CPMS Sales at Morningstar Research Inc.
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Emily Halverson-Duncan, CFA