h d Quarter 2011
Third
Volume XXX, No. 3
www.computerizedinvesting.com
Feature:
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Editor’s Outlook
Screening With the Big,
Safe Dividend Formula
At the end of April we launched a new weekly CI
email to give our readers more timely and frequent
reviews of useful websites, software and tech gadgets.
In addition, each week we delve into CI’s archives to
ﬁnd timeless articles that you might have otherwise
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of AAII emails, including the weekly CI email.
M
any investors seek income to supplement their
portfolio returns while at the same time insulating
themselves from market declines. In “The Little Book of
Big Dividends: A Safe Formula for Guaranteed Returns”
(John Wiley & Sons, 2010), Charles Carlson outlines a
recipe for investment success:
“Find stocks with above-average appreciation potential
and safe and growing dividends, and buy them at attractive prices.”
Carlson believes investors can achieve this success
by using proprietary ratings, which he makes available online for free. In this article, we discuss Carlson’s
investment philosophy and then introduce his proprietary
ratings to narrow down the stock universe to a more
manageable collection of dividend-paying stocks.
Why Dividends Matter
When investing in stocks, we get paid in two ways—
with capital gains and with dividends. Combining the
Recently a comment was left online regarding a CI
two gives us a stock’s total return. While it is easy to get
article discussing the sharing of CI and AAII Journal arcaught up in the daily movement of stock prices—the
ticles with non-members (you can ﬁnd the comment in
the Messages section on page 3). The reader voiced con(continued on page 16)
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• How to use profit margins
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that article sharing gives non-memto judge a stock......................... 20
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bers access to members-only content,
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such sharing is an excellent way to
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Comparison
spread AAII’s message of unbiased
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• The best software and websites
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beneﬁt of all members and readers.
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Sharing AAII Content
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Screening With thee Big
Big,
g,
g
mula
m
Safe Dividend Formula
Feature
By Wayne A. Thorp,
rp, CFA
CFA
(continued from page 1)
capital gains element of total return—it is important not to disregard
the impact of dividends on this equation. In fact, according to Carlson,
roughly 40% of the stock market’s
long-run total return comes from
dividends.
Despite the record number of companies that omitted or cut their dividends in 2008 and 2009
(Carlson points out that
roughly one in eight S&P
500 companies reduced or
eliminated their dividend
in 2008 and about 15%
did so in 2009), most ﬁrms
are extremely hesitant to
cut the dividend once they
initiate a dividend policy.
For this reason, we tend to
see larger, more established
and mature companies paying dividends.
For Carlson, the most
important indicator of dividend safety is the payout
ratio—the percentage of a company’s
earnings that are paid out in dividends. If a company has $1.00 per
share of earnings and pays out $0.50
per share in dividends, its payout ratio is 50% ($0.50 ÷ $1.00). All else
being equal, the higher a company’s
payout ratio, the more likely it is that
the company will reduce or eliminate
the dividend when problems arise.
Carlson goes as far as to say that “the
payout ratio is the single most powerful factor in analyzing the health,
stability, and growth potential of a
stock’s dividend.”
price. Most of the dividend yields
you see quoted in the ﬁnancial press
or provided on ﬁnancial websites
are “indicated yields,” which are
calculated using the stock’s indicated
dividend instead of the last four quarters’ dividend. The indicated dividend
is calculated by annualizing the most
recent dividend: If a company’s last
quarterly dividend was $0.25 per
yield is potentially too high, Carlson
suggests comparing it to the company’s sector or industry yield; to the
yield of the overall market, as represented by an index such as the S&P
500; or to the stock’s long-term average yield. When the yield is considerably higher than these benchmarks,
Carlson feels this to be a red ﬂag of
potential problems.
“For Carlson, the most
important indicator of
dividend safety is the payout
ratio—the percentage of a
company’s earnings that are
paid out in dividends.”
Don’t Be Tempted by
Yield
When looking for dividend-paying
stocks, many investors begin by
focusing on stocks with the highest
dividend yields. The dividend yield of
a stock is calculated by dividing the
total dividends paid out over the last
year (last four quarters) by the share
16
share, its indicated dividend would
be $1.00 ($0.25 × four quarters).
With a current share price of $20,
the indicated yield would be 5%
($1.00 ÷ $20).
However, Carlson cautions against
using yield as a primary screening
ﬁlter. His reasoning is that yield is a
proxy for risk, with unusually high
yields hinting at potential problems
with the ﬁrm. For Carlson, the higher
the dividend yield, the greater the
risk that the dividend will be omitted
or cut.
Carlson points out that a stock’s
yield will rise because of two events:
1) the dividend increases and/or
2) the stock price falls. He views
yield as a proxy for risk because more
often than not, very high dividend
yields are caused by falling stock
prices, not by rising dividends. A
rapidly declining stock price is a very
good indicator that there is something wrong with a company.
In order to determine if a stock’s
Seeking DividendPaying Stocks
When seeking out dividend-paying stocks, Carlson
stresses the importance of
evaluating dividends and
yields differently. He suggests that dividend investors
consider the following:
• Safety and dependability
of the dividend: Bigger
isn’t always better when
it comes to dividend
yield. As we have stated,
Carlson views dividend
yield as a proxy for risk. A yield
is useless if the company can’t
support the dividend payment
going forward. Carlson wants a
“big” dividend that is going to be
around today, tomorrow and well
into the future.
• Capital gains potential of the
stock: Carlson isn’t merely an
income investor. He is a total
return investor. Therefore, he
does not ignore the capital gains
prospects of a stock. As he puts
it, a “big” yield is meaningless
in the face of signiﬁcant price
losses.
• Yields on alternatives: When
considering dividend yields,
Carlson cautions against getting
wrapped up in absolutes. Instead, he suggests comparing the
yield of a stock to those of other
investments. Even if, in absolute
terms, the yield seems low, the
stock’s yield may be favorable
compared to the alternatives.
Computerized Investing
Feature
• Yields on comparable investments: It is also a good idea to
compare dividend yields across
industry/sector and market
benchmarks. When you ﬁnd a
yield that is signiﬁcantly higher
than that of its industry or the
overall market, there is a strong
likelihood that this dividend is
about to go away.
• Pretax versus aftertax yields:
Carlson reminds the reader that
it is important to consider both
the pretax and aftertax yields,
especially if you are holding investments outside of a retirement
account.
• Dividend growth potential:
Lastly, Carlson stresses the importance of seeking out dividendpaying stocks generating the
best total returns over time. As a
result, you need to consider the
dividend growth potential of a
stock. However, he warns against
using your own personal income
needs in selecting dividendpaying stocks. Just because you
“need” a 6% yield doesn’t mean
that you should be seeking out
stocks yielding 6%. Instead, he
advocates picking dividend-paying stocks on their merits. This
is why he doesn’t use dividend
yield as a primary ﬁlter for
dividend-paying stocks. Instead,
he ﬁlters stocks based on proprietary ratings that attempt to
gauge the total return potential
of a stock and uses yield only as
a secondary ﬁlter.
BSD Formula
In his book, Carlson introduces his
big, safe dividend (BSD) formula for
picking attractive dividend-paying
stocks. Actually, he discusses two
BSD formulas: basic and advanced.
However, for this article we focus on
the basic BSD approach, reserving
the advanced formula for a future
article.
Basic BSD Formula
Carlson’s basic BSD formula is
Third Quarter 2011
based on two premises:
• A company cannot pay dividends
if it doesn’t have the money to
do so; and
• You should choose stocks based
on their total return potential,
not just dividend return (yield).
His basic BSD formula uses two
data points to address these issues:
• Payout ratio; and
• Overall Quadrix score.
Payout Ratio
As we mentioned earlier, a stock’s
payout ratio measures how much of
a company’s proﬁts (earnings) are
paid out as dividends. For Carlson,
the payout ratio is an indicator as to
whether a company can maintain and
grow its dividend. The smaller the
percentage of earnings a company
pays out in dividends, the more of a
“cushion” it has to grow the dividend, or at least maintain it should
earnings decline.
For Carlson, a “safe” payout ratio
is anything below 60%. While he
admits that using an absolute cutoff
will eliminate stocks in industries
with historically high payout ratios, he feels better knowing he is
also eliminating stocks with potentially higher risk (as indicated by the
higher dividend yield).
Quadrix Score
The second element of Carlson’s
basic BSD formula is the Quadrix
Score—a proprietary stock-rating
system developed by Dow Theory
Forecasts (now called Horizon
Publishing), the investment newsletter publisher where Carlson works.
Carlson uses this multivariate system
to identify stocks demonstrating
balanced and broad growth. The
Quadrix system ranks over 4,000
stocks based on more than 100 variables across six categories:
• Momentum (growth in earnings,
cash ﬂow and sales),
• Quality (return on investment,
return on equity and return on
assets),
• Value (price-to-sales, price-earnings and price-to-book ratios),
• Financial strength (debt levels),
• Earnings estimates, and
• Performance (relative stock price
performance).
According to Carlson, some
variables are weighted more heavily
based on their past effectiveness. The
overall Quadrix score is a weighted
average of the six category scores.
However, the Quadrix stock rating
system is a “black box,” or proprietary, system, so Carlson does not go
into too many speciﬁcs as to how the
score is calculated or the weightings
assigned to the different variables.
The Dow Theory Forecasts website
does offer some details as to how the
Quadrix Score is calculated (www.
dowtheory.com/quadrix_explained.
asp), but is still not explicit about its
construction.
The overall Quadrix score is a
percentile ranking, so a reading of 90
means that a stock scores better than
90% of the stocks in the Quadrix
universe. Carlson focuses on stocks
that rate in the upper quartile (those
with an overall Quadrix score of 75
or higher out of a possible 100).
To help investors, Carlson’s website
(www.bigsafedividends.com) provides
the payout ratios and overall Quadrix
scores for all the dividend-paying
stocks in the S&P 1500 composite.
Access to the site is free, but you are
required to register using an email
address.
Basic BSD Formula Filters
Carlson goes on to describe a
simple stock-ﬁltering system based on
his basic BSD formula:
Filter 1: Focus on stocks with payout ratios of 60% or less.
Filter 2: Focus on stocks with overall Quadrix scores of 75 and higher.
Since the Quadrix scoring system
is proprietary, we used Carlson’s free
website to do the ﬁltering for us.
We found payout ratio and overall
Quadrix scores for the 887 stocks in
the S&P 1500 that pay a dividend
as of May 18, 2011. This is roughly
20% of the entire 4,000+ Quadrix
stock universe. While it’s a limited
17
Feature
Table 1. Simple BSD Formula Screening Results
Company (Ticker)
Intel Corp. (INTC)
Chevron Corp. (CVX)
International Paper Co. (IP)
Abbott Laboratories (ABT)
Lilly (Eli) & Co. (LLY)
Comtech Telecommun (CMTL)
Olin Corp. (OLN)
Lockheed Martin Corp. (LMT)
Block H & R Inc. (HRB)
Conocophillips (COP)
Cato Corp. Class A (CATO)
Northrop Grumman Corp. (NOC)
Foot Locker Inc. (FL)
PPL Corp. (PPL)
Tompkins Financial Corp. (TMP)
Superior Industries Int’l (SUP)
Tower Group Inc. (TWGP)
M & T Bank Corp. (MTB)
DPL Inc. (DPL)
McDonald’s Corp. (MCD)
Strayer Education Inc. (STRA)
Mattel Inc. (MAT)
Fidelity National Financial (FNF)
NYSE Euronext (NYX)
Dime Community Bancshares (DCOM)
Price
($)
24
103
32
54
39
28
23
80
16
73
26
65
23
28
40
22
24
89
30
82
120
27
16
35
14
Dividend
($)
0.73
3.12
1.05
1.92
1.96
1.00
0.80
3.00
0.60
2.64
0.74
2.00
0.66
1.40
1.36
0.64
0.75
2.80
1.33
2.44
4.00
0.92
0.48
1.20
0.56
Yield
(%)
3.0
3.0
3.3
3.6
5.1
3.6
3.5
3.8
3.6
3.6
2.9
3.1
2.9
5.0
3.4
2.9
3.2
3.1
4.4
3.0
3.3
3.4
3.0
3.4
4.0
Payout
Ratio
(%)
33
30
37
45
41
40
39
39
41
39
38
30
59
49
43
32
25
47
56
52
41
50
27
48
44
Quadrix
Score
100
98
97
94
94
92
92
91
90
88
86
86
85
85
83
82
81
80
79
78
78
76
76
75
75
Description
semiconductor chips
oil & natural gas
paper & packaging
health care prods
pharmaceuticals
communications solutions
industrial bleach prods
advanced tech sys for govt
tax & business servs
oil & natural gas
women’s apparel stores
advanced tech sys for govt
athletic footwear
electric utility holding co.
bank holding co.
aluminum vehicle wheels
insurance prods
bank holding co.
electric utility holding co.
value-priced restaurants
post-secondary education
toy manufacturer
insurance holding co.
ﬁnancial markets operator
bank holding co.
Source: Big Safe Dividends, www.bigsafedividends.com. Data as of May 18, 2011.
subset of the entire Quadrix universe,
this is a good starting point for those
looking to invest in dividend-paying
stocks.
We began by exporting the Web
table to Excel by right-clicking on the
table and selecting the “Export to Excel” menu option. Doing so allowed
us to manipulate the data more easily
than can be done with the Web table.
Once we had the data in an Excel
spreadsheet, we sorted the table for
those stocks with a positive payout ratio less than or equal to 60%
(0.60). Of the 887 companies in the
listing as of May 18, 2011, 50 had
negative payout ratios and another 39
did not have a payout ratio listed. Of
the 798 remaining companies, 640
had a payout ratio no higher than
60%.
We then copied this pared-down
list of companies to a new worksheet
and sorted the remaining stocks in
descending order by their overall
Quadrix score. Here, we are looking
for Quadrix Scores of 75 or higher.
Of the 640 companies with payout
18
ratios between 1% and 60%, 238
had an overall Quadrix score of 75 or
above.
While we narrowed down the initial
database of 887 companies to 238,
this is still a rather unwieldy collection of stocks. As our ﬁnal sorting
criterion, we looked to the dividend
yield. Previously, we mentioned that
Carlson discourages investors from
using dividend yield as a primary ﬁlter when looking for dividend-paying
stocks. But since we used the payout
ratio to isolate stocks that Carlson
judges have a safe dividend that is
likely to grow as well as those with
the potential for “balanced and broad
strength,” as indicated by the overall
Quadrix score, we can now use yield
as a secondary ﬁlter by highlighting
those remaining stocks with the highest dividend yields.
Overview of Passing
Companies
Table 1 lists the 25 stocks with the
highest dividend yields as of May
18, 2011, that have both a payout
ratio less than or equal to 60% and
an overall Quadrix score of 75 or
higher. These 25 stocks have dividend yields ranging from a high of
5.1% [Eli Lilly & Co. (LLY)] to a
“low” of 2.9% [Cato Corp. (CATO),
Foot Locker Inc. (FL) and Superior
Industries (SUP)].
Foot Locker Inc. makes the ﬁnal
listing with its payout ratio of 59%,
just below the 60% cutoff. At 25%,
Tower Group Inc. (TWGP) has the
lowest payout ratio among these 25
stocks.
Finally, the overall Quadrix scores
for these 25 stocks range from a low
of 75, the hurdle score, for Dime
Community Bancshares (DCOM) and
NYSE Euronext (NYX), to a high of
100 for Intel Corp. (INTC).
Table 2 presents summary statistics
for the 215 stocks with a payout ratio
less than or equal to 60% and an
overall Quadrix score of 75 or higher.
Carlson’s simple BSD formula
screen requires stocks to have payout
ratios no higher than 60%. The mediComputerized Investing
Feature
an payout ratio for the current group
of passing companies is 18.8%, while
the typical exchange-listed stock has
a payout ratio of 3.6%.
In order to receive a high value
score, the Quadrix system looks at
such ratios as the price-earnings,
price-to-sales, price-to-cash-ﬂow, and
price-to-book ratios; dividend yield;
and price-earnings ratio relative to
expected earnings growth (forward
PEG). These ratios are compared to
the average level of the ratios over
the last three and ﬁve years, and
stocks that are most attractively valued relative to these historical levels
receive the highest value score.
The median price-earnings ratio for the 215 companies passing
Carlson’s simple BSD formula screen
as of May 18, 2011, is 15.5. This is
slightly lower than the price-earnings
ratio of the typical exchange-listed
stock, which is 17.6. The price-tobook ratio of these companies is
2.5, which is higher than the 1.7 for
exchange-listed stocks. Furthermore,
as we mentioned earlier, most stocks
do not pay a dividend. Therefore, the
median dividend yield for exchangelisted stocks is 0%, while the median
for these simple BSD formula stocks
is 1.5%.
To score high in terms of quality in
the Quadrix system, a company must
demonstrate strong growth in sales,
earnings, cash ﬂow, common equity,
and dividends over the last one, three
and ﬁve years. The stocks passing
the simple BSD formula screen as of
May 18, 2011, have
Table 2. Simple BSD Formula Portfolio Characteristics
a median ﬁve-year
Simple BSD Exchangehistorical earnFormula
Listed
ings growth rate
Portfolio Characteristics (Median)
Screen
Stocks
of 10.3%, which
Price-earnings ratio (X)
15.5
17.6
dwarfs the median
Price-to-book-value ratio (X)
2.5
1.7
Dividend yield (%)
1.5
0.0
growth rate of 3.5%
Payout ratio (%)
18.8
3.6
for exchange-listed
EPS 5-yr. historical growth rate (%)
10.3
3.5
stocks. Our startEPS 3-5 yr. estimated growth rate (%)
11.7
12.6
ing universe was
Dividend 5-yr. growth rate (%)
9.4
0.0
Market cap ($ million)
6,459.9
554.6
dividend-paying
Relative strength vs. S&P* (%)
8
(3)
constituents of the
S&P 1500, which
*S&P 500 index = 0.
tend to be more
Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of May 13, 2011.
mature, slowergrowing ﬁrms. As
have outperformed the S&P 1500 ina result, we see a projected earnings
dex by an average of four percentage
growth rate for the next three to ﬁve
points a year from the end of 1994
years lower than that of the typical
through 2009, and with lower risk
exchange-listed stock (11.7% verthan that of the index.
sus 12.6%). The ﬁve-year dividend
growth rate for the simple BSD
formula stocks is 9.4%.
Conclusion
Looking at performance, the
Quadrix system places a premium on
Charles Carlson is a total return
strong short-term performance from
investor looking for stocks providing
two to 12 months. The stocks curincome in the form of safe dividends
rently passing Carlson’s simple BSD
that he expects to grow over time,
formula screen have outperformed
as well as a strong ﬁnancial foundathe S&P 500 index by 8% over
tion to generate price gains. He uses
the last 52 weeks, while the typical
his company’s Quadrix stock rating
exchange-listed stock has underpersystem to ﬁlter the dividend-paying
formed the index by 3% over the
stock universe to ﬁnd such candisame time period.
dates.
It is impossible for us to indepenQuantitative systems such as
dently test the performance of CarlCarlson’s are excellent ways for
son’s simple BSD formula. According
investors to hone in on attractive
to his book, a portfolio of stocks
investment candidates that warrant
meeting these criteria, rebalanced at
additional analysis. However, quantithe beginning of each year, would
tative stock selection systems are only
one piece of the selection process. A
qualitative element is equally important. For this reason, investors must
Wayne A. Thorp, CFA, is editor of Computerized Investing and
still perform their own due diligence
is AAII’s senior financial analyst. You can follow him on Twitter at
to make sure the investments they
www.twitter/ci_editor.
select meet their own time horizon
and risk tolerances.
Third Quarter 2011
19