What are we looking for?
With the big gains in U.S. stocks over the past few months, many dividend-paying companies now appear expensive. We wanted to see whether there are still reasonably priced stocks with attractive yields.
How we did it
Craig McGee, senior consultant at CPMS Morningstar Canada, first checked to see how pricey the market looks. Using the CPMS database, he calculated that dividend-paying stocks in the S&P 500 were trading for 14.7 times their adjusted operating earnings over the past four quarters, based on values as of the end of August.
That is not particularly expensive. Over the past 10 years, the average price-to-earnings ratio for these stocks was 14.9, suggesting that dividend-payers in the S&P 500 aren't as richly valued as some investors think and may have room for further gains if earnings continue to expand.
To find firms that appear the most reasonably valued, he used CPMS to select the 20 U.S. stocks with the best combination of low price-to-earnings ratios, low price-to-cash-flow ratios and low price-to-sales ratios. (All of them are based on the past four quarters' results.)
To make the grade, a stock had to be in the top 30 per cent of the CPMS U.S. database on the above criteria, with an expected yield of at least 3 per cent. Any stock for which analysts had reduced their earnings estimates over the past three months was ruled out.
More about Morningstar
Morningstar 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.
What we found
Mr. McGee back-tested the strategy assuming that an investor held equal dollar amounts of each stock until a stock fell below the 30 per cent mark, at which point it was replaced with the best ranking alternative.
Since Dec. 31, 1993, this strategy would have generated an annualized return of 12.1 per cent, versus 8.7 per cent for the S&P 500 total return index. Remember, though, that past results don't necessarily predict future success.