What are we looking for?
Small-cap dividend payers not found in the much-followed S&P/TSX Composite Index.
The screen
Last week, I highlighted some profitable U.S. mid-cap names that might be flying under your radar. Today, we compile a similar strategy for the Canadian market, but this time focusing on small-cap companies that show steady earnings, sales and profitability in addition to paying sustainable dividends. To find these names, I used Morningstar CPMS to rank the 478 stocks that are not currently in the S&P/TSX Composite Index on the following factors:
- Three-year sales and earnings growth (how much, on average, top and bottom lines have grown in each of the past three years);
- Three-year deviation of earnings per share, return on equity and price (a measure of how consistent earnings, profitability and the stock price have been over the past three years – lower figures preferred);
- Dividend yield.
Only companies with a market cap between $100-million and $560-million were considered (these figures are meant to remove the bottom and top one-third of the universe by size). Additionally, to ensure that dividends payed are somewhat sustainable, we only considered companies with a dividend payout ratio against cash flows and trailing earnings of less than 60 per cent and 80 per cent, respectively.
What we found
I used Morningstar CPMS to back-test this strategy from October, 2009, to March, 2021, using a maximum of 15 stocks with no more than three for every economic sector. At the end of each calendar month, stocks were sold if they fell below the top 35 per cent of the index based on the aforementioned metrics or if dividend payout ratios exceeded the above limits. When sold, they were replaced with the highest ranked qualifying stock not already held in the portfolio. To account for the illiquid nature of smaller stocks, a 2-per-cent liquidity cost was applied in the backtest, implying stocks were sold at 2 per cent lower than the closing price of the month and bought for 2 per cent higher. Over this period and on this basis, the strategy produced an annualized total return of 14 per cent, while the S&P/TSX SmallCap Index (total return) advanced 5.8 per cent.
The stocks that meet the requirements to be purchased today are listed in the accompanying table. This article does not constitute financial advice. It is always recommended to speak with a financial adviser or professional before investing.
More about Morningstar
Morningstar Research Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. Morningstar offers an extensive line of products and services for individual investors, financial advisers, asset managers, retirement plan providers and sponsors, and institutional investors. Morningstar Direct is the firm’s multi-asset analysis platform built for asset management and financial services professionals. Morningstar Canada on Twitter: @MorningstarCDN.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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