September was another miserable month for equity investors, with high levels of volatility and declining share prices. Since the start of May until the end of September (the seasonally weak period for equities), the MSCI Global Equities Index declined 9.5%, closely followed by the Standard & Poor’s 500-stock index, with a 9.2% decline. Dividend-based investment strategies were not spared, with the S&P Global Dividend Aristocrats Index dropping 11.9% during this period.

We compare the performance of the Dividend Champions Portfolio against the broad Canadian equity market index, as this is the universe from which we select stocks for this portfolio. In the short time since the portfolio’s inception, the Dividend Champions performed considerably better than the benchmark, so investors who follow this portfolio’s selections are getting on balance the betterperforming stocks from the Canadian universe. And yes, the absolute performance, especially when converted to U.S. dollars, is not great, but this has been a difficult year for stocks on both sides of the border.

The highlights from the Dividend Champions Portfolio during the month were solid returns from Fortis Inc. (TSX: FTS, OTC: FRTSF), North West Company (TSX: NWC, OTCNWTUF) and Canadian National Railway (TSX: CNR, NYSE: CNI), with increases of 7%, 5% and 4%, respectively.

The poor run for the companies with links to energy and commodities production continued in September, with Potash Corp. (TSX: POT, NYSE: POT), Inter Pipeline Ltd. (TSX:IPL, OTC: IPPLF) and TransCanada Corp. (TSX: TRP, NYSE: TRP) all among the bottom performers with declines of 20%, 12% and 7%, respectively.

The share price of Potash Corp. was hit particularly hard after competitor potash producer Mosaic announced that it would curtail production as a result of slow North American demand. We believe that Potash Corp. offers good value at the current levels, and we moved the previous Hold advice to Buy on September 25.

Fair Value Is the New Price Limit

Regular readers of this publication will note that we changed the “Buy Limits” in the table to “Fair Value.” This is the price at which investors can buy the stock and expect to receive a reasonable return over the medium to long term. Reasonable return is the required annual return based on the risk-free rate plus an appropriate premium for taking on the risk of investing in a particular stock. For most of our stocks this return varies between 7% and 12% per year.

We use several valuation methods to estimate fair value, but as the Dividend Champions are mostly stable dividend-paying stocks, a dividend-discount model is our primary tool.

Key assumptions that go into the computer model for calculating the fair value based on the dividend-discount model are:

The risk-free rate (we use a conservative assumption of 3% to reflect a possible return to normal interest rates at some point during the next three years)

The expected return on the overall equity market (we use a 9% per year return, which is the long-term annual return for the Canadian stock market)

The beta estimate for each individual company (we use five-year estimates of beta adjusted for the latest indications of company-specific risk including the state of the balance sheet and industry developments)

Estimates of dividend growth for each company over the next three years and estimates of long-term sustainable growth.

Although we have to make several assumptions to calculate each stock’s fair value, we believe that our assumptions are conservative and should provide investors with some reassurance that these stocks represent a good buying opportunity when the prices are below their fair values. Consequently, fair value should be considered the new price limit.