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Issue No. 22 – April 18, 2005 Prescott, Arizona Systems@WiserTrader.com
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1.0 Trading
This issue will describe a dividend filter that can be used with a flexible stock picking tool to independently create one’s own watch list. Stock picking tools found at the web site, such as Stock Picker RT and Investor 3000, are essential to a successful trading system. To further boost your trading profits, low cost stock and option advisories are available at http://www.wisertrader.com .
1.1 A Dividend Filter
Dividends contribute to returns in any market situation, while the income appeal of dividend-paying stocks helps to limit steep losses if the market declines. A dividend-yield strategy can help you find potentially undervalued stocks with reduced downside risk, provided the dividend is secure. Because mostly mature firms pay significant dividends, dividend analysis is geared toward established firms that are past their explosive growth and cash-consuming stage.
A stock's dividend yield is computed by taking the expected dividend over the next year-and dividing it by the share price. For most stocks, the indicated dividend is the most recent quarterly dividend multiplied by four, although some firms have switched to a single annual dividend payment. If a stock is paying an indicated dividend of $1 per share and is trading with a price of $40, its dividend yield is 2.5% ($1 ÷ $40 = 0.025, or 2.5%). If a stock's price rises faster than its dividend, the dividend yield will fall, indicating that the price may have been bid up too far and may be ready for a decline. Conversely, if the dividend yield rises to a high level, the stock may be poised for an increase in price if the dividend can be sustained.
Like all basic value-oriented techniques, the dividend-yield strategy attempts to identify investments that are out of favor. Contrarian techniques such as this are based on the premise that markets tend to overreact to good and bad news and push the price of a security away from its intrinsic value. Value investors hope to identify under priced securities through the use of a consistent set of rules called a valuation model.
© 2005 Desert Mountain Systems, LLC. Members of wisertrader.com are neither licensed brokers nor licensed advisors. Trades discussed represent recommendations made by the editor for the wisertrader.com portfolio. The newsletter and web site are for information only and should not be considered as personal advice. While it is believed that the posted information is factual, mistakes can be made in transcription. Investors should trade stocks only after verifying all information and consulting with a licensed broker or adviser. Desert Mountain Systems markets third party trading systems but has no other affiliation with trading system companies.
Screening is just the first stage in this process and it involves scanning a group of securities to find those that merit further in-depth analysis. Absolute or relative levels may be used in screening for high-yield stocks. A screen requiring an absolute level might look, for example, for a minimum dividend yield of 3% before an investment is considered. Absolute screens can lead to passive market timing as cash levels tend to build up when investors cannot find suitable investments that meet the minimum requirements during times of market extremes. Also, screens that only look at absolute levels can be weak because they may turn up securities from a single industry that traditionally has higher dividend yields, such as utilities or REITs.
Screens based on relative levels compare the yield against a benchmark that may fluctuate, such as the current dividend yield for the S&P 500. In this case, the investor does not require that the yield meet some minimum level, but instead that it maintains its historical relationship with the benchmark figure. Common screens examining relative yields include comparisons against some overall market level, industry level, historical average, or even some interest rate benchmark. This AAII screen is performed using a historical average as the benchmark.
The first filter requires that a stock trade on the NYSE, AMEX or NASDAQ. This filter helps to establish minimum levels of liquidity. Next, the filter excludes closed-end mutual funds, which have unique financial characteristics requiring that they be analyzed separately. The screen then requires that a company have seven years of price and dividend records.
The screen should include a time period that covers both the up and down periods of a market and economic cycle. Selecting a time period is a balance between using one that is too short and only captures a segment of the market cycle and one that is too long and includes a time period that is no longer representative of the current company, industry, or market. Periods of between five and 10 years are most common for these types of comparisons. This screen looks for companies that have paid a dividend for each of the last seven years and have never reduced their dividend.
Dividend levels are set by the board of directors based on consideration of the current company, industry, and economic conditions. Because dividend cuts are tantamount to an announcement that the firm is financially distressed, dividends are set at levels that the company should be able to afford throughout the economic cycle. A lack of dividend growth or a decline in the dividend growth rate can also be troubling, especially after a period of regular annual dividend increases. Nearly 10% of the companies paying a dividend over the last seven years had not increased their dividend payout over that time period. Investors such as Benjamin Graham required that stock dividends at least keep pace with inflation. This screen is even more aggressive and demands an annual increase in the per share dividend payout for each of the last six fiscal years. The next filter requires that the company's current dividend yield be higher than its seven-year average dividend yield. This filter seeks out companies whose dividends have increased faster than increases in share price, or whose current share price has declined recently.
While it might seem that the screening process
should be over with this last filter, before a company can be considered for
purchase the security of the dividend must be examined. A high dividend yield
may be a signal that the market expects the dividend to be cut shortly and has
pushed down the price accordingly. A high relative dividend yield is a buy
signal only if the dividend level is expected to be sustained and increased
over time. Measures do exist that help to identify the safety of the dividend.
The payout ratio is perhaps the most common of these and is calculated by
dividing the dividend per share by earnings per share. Generally the lower the number,
the more secure the dividend. Any ratio above 50% is considered a warning flag.
However, for some industries, such as utilities, ratios around 80% are common.
A 100% payout ratio indicates that a company is paying out all of its earnings
in the form of dividends. A negative payout ratio indicates that a firm is
paying a dividend even though earnings are negative. Firms cannot afford to pay
out more than they earn in the long term. The screen requires a payout ratio of
between 0% and 85% for utilities and between 0% and 50% for firms in other
sectors.
Dividends are paid in cash, so it is also important to examine the liquidity of a company. Financial strength helps to indicate liquidity and to provide a measure of safety for the dividend payout. One must consider both the short-term obligations of the company along with long-term liabilities when testing for financial strength. Common measures of the longer-term obligations of the company include the debt-to-equity ratio (which compares the level of long-term debt to owner's equity), debt as a percent of capital structure (long-term debt divided by capital, which includes long-term sources of financing such as bonds, capitalized leases, and equity), and total liabilities to total assets.
The screen uses the ratio
of total liabilities to assets because it considers both short-term and
long-term liabilities. Acceptable levels of debt vary from industry to
industry, so the screen looks for companies with total liabilities to assets
below the norm for their industry. Higher ratios indicate greater financial
leverage and risk. The financials and utilities passing have much higher values
than the stocks in 
the
consumer sectors. It is also important to examine the historical record of earnings.
Dividend growth cannot deviate for very long from the level of earnings growth,
so the pattern of earnings growth will help to confirm the stability and
strength of the dividend. Ideally, earnings should move up consistently. The
final screen requires growth in earnings over the last three years greater than
the norm for the industry.
Because I am growth oriented, a further requirement was added so that the PEG ratio (Price to earnings ratio divided by the 5 year expected growth rate) be less than or equal to 1.2.
In summary, screening for relative high dividend yield is based upon the time-honored rule of buying low and selling high. To succeed at this strategy, you need to develop a set of tools not only to identify which stocks have relatively high dividend yields, but also which of those stocks have the strength to bounce back. As is true for any screen, the list of passing companies represents only a starting point for further in-depth analysis.
Stocks passing all of the above screens are: DHI, DOV, DRL, HD, HDI, ITW, KRB, MSBK, USB and WFC. Remember that these candidates are for consideration for the long term
2.0 Market Analysis
Industry leadership is given in Table 1 where leading industries are ranked from highest to lowest.
Table 1