Dividend stocks for low excitement, high returns

The Basics

Dividend stocks for low excitement, high returns
Boring? Maybe. But here's a screen for finding dividend stocks that will have you yawning all the way to the bank.


By Harry Domash (Author of "Fire Your Stock Analyst")

It's time to make the case for "boring" dividend stocks.

From a tax perspective, they're hard to beat: Thanks to recent tax-law changes, most dividends are taxed at only 15%. Previously, dividends were hit at full income-tax rates.

And these stocks have been anything but boring when it comes to returns. According to Standard & Poor's, dividend-paying companies returned 18.4% last year, compared with 13.7% for those that didn't pay dividends and 8.6% for the Nasdaq, home to so many of the tech stocks investors find so exciting.

I've devised a screen for finding promising -- and, yes, boring, but only in the sense that they won't keep you up at night -- dividend-paying candidates. The screen pinpoints well-established companies that have solid earnings and dividend growth track records.

You won't get-rich-quick with these stocks. But most are expected to grow earnings between 10% and 15% annually over the next five years. So, over time, you can expect their share prices to move up at about the same rate. Combine that expected -- though by no means guaranteed -- price appreciation with 2% to 5% dividend yields, and you can expect annual returns in the 12% to 20% range, or roughly 16% per year.

To put that in perspective, at a 16% compounded annual return, $1,000 turns into $2,100 in 5 years. The S&P 500 ($INX) managed less than an 11% average annual return, and the Nasdaq Composite ($COMPX) returned around 4% over the past 10 years.

I've intentionally excluded higher-yielding stocks such as mortgage REITs (real-estate investment trusts that invest in mortgages) and royalty trusts (trusts, frequently based in Canada, that invest in oil and natural-gas resources) that often pay dividends equating to double-digit yields. These may be worthwhile investments, but require special analysis that I don't have room to cover here.

Here's how the screen works. You can use it as is, or as a starting point which you can revise to suit your needs.

Dividend yield: Set upper limits, too

If you're rusty on your stock-market math, dividend yield is a company's next 12 months' dividends divided by its current share price. For example, your yield would be 10% if you paid $10 per share for a stock expected to pay out $1 per share over the next year ($1/$10). However, another investor's yield would only be 9.1% if he bought the same stock a week later for $11 per share ($1/$11).

I arbitrarily set my minimum yield at 2.25%, which was the prevailing return on low-risk money market funds when I researched this column. Obviously, the lower the minimum yield, the more stocks you'll get. For example, 1,688 U.S.-listed stocks currently pay at least 2.25%. But reducing the minimum to 1.5% increases the field to more than 2,200 stocks.

Screening Parameter: Current Dividend Yield >= 2.25

For dividend yield, higher is not always better. High-yielding stocks get that way because many investors see them as risky.

Think about it.

Say a stock is expected to pay $1 per share in dividends over the next year and is changing hands at $10 per share, equating to a 10% yield. Given current money market rates, buyers would flock to buy a stock yielding 10% if they thought the dividend was rock-solid. The buying pressure would push the share price up until the yield dropped closer to market rates. In my experience, stocks with dividends seen as safe don't trade at yields much above the 4% to 4.5% range.

So I set my maximum acceptable dividend yield at 5%. Increase the maximum to 8% if you want to see riskier stocks. Sometimes cigarette makers such as Altria Group (MO, news, msgs) pay yields in the 7% range.

Screening Parameter: Current Dividend Yield <= 5

Look for dividend growth
You win two ways if one of your stocks ups its dividend. The higher payouts increase your yield and the dividend hike usually drives the share price higher.

History is truly the best teacher when it comes to evaluating dividend growth prospects. Companies with a record of strong historical dividend growth usually are committed to continuing that policy. Conversely, companies that haven't consistently increased dividends probably prefer to use their extra cash for other purposes.

I require at least 5% average annual dividend growth over the past five years. Ideally, you'd like to see even higher growth, but the recent recession prevented many firms from increasing their payouts. Increase the requirement to 7% or 8% if your screen turns up too many candidates.

Screening Parameter: 5-Year Dividend Growth >= 5

Profits power dividends

Since dividends come from earnings, you should draw your dividend candidates from the ranks of profitable companies. Return on equity (ROE), which is net income divided by shareholders equity (book value), is a widely used profitability gauge. But profitability standards vary between industries. So instead of setting an arbitrary minimum, I require that passing candidates must at least equal their industry average ROE.

Screening Parameter: Return on Equity >= Industry Average ROE

Stick to the strongest banks

Banks have been good dividend-payers in recent years, so my first try using this screen turned up several bank stocks. However, many small or regional banks enjoyed exceptionally strong profits from making and servicing home mortgages. Rising interest rates are squeezing their mortgage profit margins and reducing the demand for new mortgages. So this phase of the economic cycle is not the time to bet heavily on banks.

The leverage ratio measures debt by dividing total assets by shareholder's equity, and it's useful here. A company with no debt would have a 1.0 leverage ratio. The higher the debt, the higher the ratio. Banks are often highly leveraged, many with ratios in the 10-to-15 range, which is understandable, considering that cash is a bank's inventory.

I set my maximum allowable leverage at 10, in order to find only those banks with relatively strong balance sheets. Adjust that limit up if you want your screen to turn up more banks, and down for fewer banks.

Screening Parameter: Leverage Ratio <=- 10

Avoid future losers

A company like General Motors (GM, news, msgs) may have great dividend history, but a dismal outlook. In fact, many analysts expect GM to cut its dividend in the not-too-distant future.

You don't need to spend your time evaluating each candidate's future prospects because stock analysts do that all day long. So I piggyback on their efforts and rely on analysts' long-term earnings forecasts and buy/sell recommendations to rule out stocks likely to cut future dividends.

First, since dividends come from earnings, I look for consensus forecasts calling for at least 10% minimum average annual earnings growth over the next five years. Even if the forecasts are wrong, the likes of GM and Eastman Kodak (EK, news, msgs) are unlikely to pass this test.

Screening Parameter: EPS Growth Next 5Yr >= 10

As a backup check, I also look at analyst's consensus buy/sell recommendations.
Something's fishy if analysts are forecasting strong long-term earnings growth, but advising investors to sell the stock. Dividend investing is about avoiding unnecessary risk. It doesn't make sense to consider stocks that analysts say you should sell.

Screening Parameter: Mean Recommendation >= Hold

Follow the pros

Institutional buyers such as mutual funds and pension plans more tuned-in to what's happening in the market than you and I will ever be. If the big boys won't own a stock, we shouldn't either.

Institutional ownership is measured as a percentage of outstanding shares and can range from zero to 95%. There's no cast-in-concrete number that says a stock has enough institutional ownership. As a rule of thumb, I set a 40% minimum. Reduce the minimum to as low as 30% if you don't get enough candidates.

Screening Parameter: % Institutional Ownership >= 40

My screen turned up 19 stocks in a variety of industries. The list included one savings and loan and three regional banks. However, MBNA (KRB, news, msgs), which is listed as a regional bank, is primarily a credit card issuer. As always, the results of this or any screen should be considered research candidates, not a buy list.

Dividend Winners

Company----Price*----Industry

Abbott Laboratories (ABT, news, msgs)
47.2
Drug manufacturers - major

Allstate (ALL, news, msgs)
54.63
Property & casualty insurance

Autoliv (ALV, news, msgs)
46.9
Autoparts

Avery Dennison (AVY, news, msgs)
61.21
Paper & paper products

Bemis (BMS, news, msgs)
31
Packaging & containers

Eaton Vance (EV, news, msgs)
23.08
Asset management

Fidelity National Financial (FNF, news, msgs)
32.45
Surety & title insurance

General Electric (GE, news, msgs)
35.5
Conglomerates

Harbor Florida Bancshares (HARB, news, msgs)
33.59
Savings & loans

Kinder Morgan (KMI, news, msgs)
76.24
Gas utilities

Limited Brands (LTD, news, msgs)
24.65
Apparel stores

Lincoln Electric Holdings (LECO, news, msgs)
29.56
Machine tools & accessories

Masco (MAS, news, msgs)
34.65
Industrial equipment & components

MBNA (KRB, news, msgs)
24.9
Regional - mid-Atlantic banks

PartnerRe (PRE, news, msgs)
64.27
Property & casualty insurance

Spartech (SEH, news, msgs)
19.32
Rubber & plastics

Synovus Financial (SNV, news, msgs)
27.78
Regional - mid-Atlantic banks

U.S. Bancorp (USB, news, msgs)
28.57
Regional - Midwest banks

Worthington Industries (WOR, news, msgs)
19.2
Steel & iron

*Price of position at the time of original publish date.

Even though these stocks look good now, circumstances change over time. Check your stocks every six months or so, and sell any that analysts are advising selling or that no longer have strong long-term earnings-growth forecasts.

At the time of publication, Harry Domash did not own or control positions in any of the stocks mentioned in this article. Domash publishes the Winning Investing stock and mutual fund advisory newsletter and writes the online investing column for the San Francisco Chronicle. Harry has two investing books out, the most recent being "Fire Your Stock Analyst," published by Financial Times Prentice Hall.

http://articles.moneycentral.msn.com/Investing/InvestingForIncome/DividendStocksForLowExcitementHighReturns.aspx