The heart of Canadian Edge is the Dividend Champion Portfolio. In current market conditions, the portfolio will have a dividend yield between 3% and 5% with dividend growth of 5% to 10% per year over time. We expect the portfolio’s total return to be around 10% per year measured over five to 10 years.

So how do we pick Dividend Champions? The key is selecting companies that not only offer an attractive yield, but also can maintain the dividend and ideally increase it. What follows are five attributes we screen for and our rationale for using these criteria.

A track record of consistent, growing dividend payments. The company should have a history of raising dividends for at least five years, preferably much longer. If the company missed or lowered a payment in the past, we need to understand why and determine whether it could happen again.

A rock-solid balance sheet. Does the company carry high levels of debt? If so, that company may not have enough cash to pay the dividend after servicing the debt. Generally speaking, we seek companies with a debt-to-capital ratio of less than 50% and an interest cover (that is, profit before interest divided by the interest bill) of more than three times. There’s no magic to these numbers—just a rule of thumb that’s worked well for me over time. Acceptable ratios also depend on the cyclicality of the underlying business because companies with stable income streams can afford to take on more debt, especially when interest rates are low.

A payout ratio with wiggle room. The best-designed business strategies can quickly unravel, leaving dividend payments at risk. The companies we select can sustain their dividend payments when times get tough. We generally look for payout ratios of less than 70%. The payout ratio reflects how much free cash flow or profit a company has to cover the dividend. Again, this is a general rule of thumb, but it, too, may vary depending on the business. The more stable the company’s profits are, the higher the acceptable payout ratio can be.

A dividend that grows faster than the rate of inflation. A company that can’t increase its dividend for a long time probably won’t provide an attractive total rate of return (dividend plus capital appreciation).

An attractive starting dividend yield. In Canada, a high-quality dividend-paying stock with a dividend yield above 2% and strong growth potential currently constitutes good value compared with bonds and cash.

Dividend Champions in a Portfolio

As an additional service, our optimal Dividend Champion Portfolio combines our best ideas in a logical portfolio and suggests weightings across the holdings. The idea is to reduce volatility more than an equal weighting of stocks can, without lowering returns. To do this we use modern portfolio theory and a fair dose of plain logic.

Of course, as a subscriber you may not want to follow these weightings, but they will at least give you some idea of which investments we emphasize and how we diversify to control the portfolio’s overall risk.

A Mock Portfolio Tests Our Theory

As an example of how this works, we’ve re-created the past performance of a theoretical Dividend Champion Portfolio. True, perfect hindsight doesn’t qualify as an investing tool, but we selected stocks using the same principles described above, concentrating on quality companies that could raise their dividends over time. The portfolio has simple equal weights in each holding, but with an eye toward sector diversification.

Measured in Canadian dollars, the portfolio’s six stocks produced a total investment return (dividend plus capital growth) of 101% over the past five years compared with a total return of 40% for the broad Canadian market index. Despite the weakness in the Canadian dollar over the past few years, the portfolio return in U.S. dollars was still a credible 61%. By comparison, the broad measure of the U.S. equity market, Standard & Poor’s 500-stock index, increased 76% over the same period, and the MSCI Global Equity Market Index, 45%.

On top of the solid return, the portfolio’s volatility or risk was considerably lower than the overall market’s, with a standard deviation reading of 7.6% compared to the market reading of 10.2%.

The portfolio’s dividend stream brings to mind a few other important points.

First, the current dividend yield (dividends divided by the original purchase price) for the portfolio is almost 6%. This handily beats the yields of cash or government bonds. Second, the dividend income grew 40% over the past five years, well ahead of inflation and its eroding effect on purchasing power.

Finally, the dividend stream covers almost 30% of the original purchase price of all the stocks, substantially reducing the capital risk of the original purchase.

The investing landscape over the next five years will be different from the past five years, but the evidence from this simple portfolio exercise as well as other formal studies illustrates the benefits of dividend-based investing.

The actual Dividend Champion Portfolio has better diversification than the theoretical six-stock portfolio and will emphasize our preferred holdings. But the same principles will apply.

To build and maintain the portfolio, we will identify Dividend Champions from the Canadian universe of stocks, including preferred shares that we may on occasion add to the portfolio. The goal will be to build a portfolio that provides sustainable income as well as reasonable growth in dividends.

If the portfolio returns between 8% and 15% per year over a full market cycle of five years or longer, our main objective has been met.

Another important metric will be the income stream that the portfolio generates.

Not only will the amount of income matter, but also its stability and growth over time.The portfolio, which will hold between 20 and 30 stocks, will be built up as market conditions allow.

As always, we will tell you about trades as soon as possible once a decision has been made. A holding will only be sold when its outlook deteriorates and an alternative with a better yield, growth or a higher total return is available.