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With low interest rates and the rise of dividend-focused funds, investors should be concerned about overpaying for dividend-yielding stocks. How can they know if the stock is overpriced by investors chasing income?

We can use the Magic Formula to find attractively priced stocks in general. In a prior article, we showed that it could be restricted to picking dividend-paying stocks without detracting from its performance. Since the Magic Formula seems to hold up to limiting picks to dividend-paying stocks, this screening method was used to create a current list of the best dividend stocks to buy in December of 2012.

This strategy is designed for income investors who are concerned that dividend-yielding stocks are becoming too pricey. It combines a screen for dividend income with Greenblatt's screen for the best stocks trading at the cheapest values.

What is the Magic Formula?

Joel Greenblatt has reported enviable annual 30.8% returns for his "Magic Formula" in his book, "The Little Book that Beats the Market." Since publishing his book, his strategy has performed well, though many analysts who have followed the "Magic Formula" have not seen 30.8% annual returns, but have seen outperformance from this strategy. His results are particularly interesting because his picks are not subjective: they are based on a simple ranking of earnings yield (EBIT/EV) and return on capital.

Magic Formula stocks have historically outperformed the market with a total portfolio which is a blend of value and growth with a beta of roughly one. This blended profile of Magic Formula picks lends itself to do-it-yourself investors as a core holding strategy. Moreover, since many of these picks have dividend yields, they can be used to create an income portfolio.

Screening for Magic Formula Dividend Stocks

The following methods were used to extract appropriate dividend-yielding stocks from Greenblatt's Magic Formula results:

Stocks were selected using the Magic Formula methodology. Each of these stocks is one of a top-50 selection with $50 million, $2 billion, or $10 billion market capitalization minimums.

Stocks were screened for dividend yield. Of these Magic Formula picks, stocks with no dividend yield or which had a dividend yield less than the 10-year treasury were removed.

Stocks were screened for payout ratio. Only stocks with payout ratios under 60% were retained. Dividend payouts under 60% are considered reasonable and sustainable.

These firms hail from many different industries and have an average dividend yield that is about twice the 10-year treasury yield:

Ticker

Company

Industry

Div Yield

Payout Ratio

ACN

Accenture

Information Technology Services

2.33%

34.0%

ADI

Analog Devices

Semiconductor - Integrated Circuits

2.91%

52.8%

BA

Boeing

Aerospace/Defense Products & Services

2.36%

30.6%

BLC

Belo

Broadcasting - TV

4.48%

37.4%

CA

CA Technologies

Application Software

4.54%

39.9%

CAH

Cardinal Health

Drugs Wholesale

2.69%

27.5%

COH

Coach

Textile - Apparel Footwear & Accessories

2.08%

28.7%

CSCO

Cisco Systems

Networking & Communication Devices

2.90%

23.0%

CVX

Chevron

Major Integrated Oil & Gas

3.36%

28.0%

DELL

Dell

Personal Computers

3.06%

5.3%

DLX

Deluxe

Business Services

3.32%

30.5%

DMRC

Digimarc

Information Technology Services

2.33%

10.2%

DOV

Dover

Diversified Machinery

2.20%

27.6%

EMR

Emerson Electric

Industrial Equipment & Components

3.23%

59.5%

GD

General Dynamics

Aerospace/Defense Products & Services

3.04%

29.6%

HLF

Herbalife

Drug Related Products

2.56%

27.1%

HRB

H&R Block

Personal Services

4.30%

59.3%

INTC

Intel

Semiconductor - Broad Line

4.47%

35.9%

JCOM

j2 Global

Internet Software & Services

2.94%

33.2%

KLAC

KLA-Tencor

Semiconductor Equipment & Materials

3.39%

34.6%

LMT

Lockheed Martin

Aerospace/Defense Products & Services

5.01%

45.7%

MANT

ManTech International

Security Software & Services

3.38%

22.1%

MDT

Medtronic

Medical Appliances & Equipment

2.44%

31.8%

MPC

Marathon Petroleum

Oil & Gas Refining & Marketing

2.31%

14.8%

MSFT

Microsoft

Application Software

3.48%

44.4%

NSU

Nevsun Resources Ltd.

Gold

2.42%

11.6%

NTI

Northern Tier Energy LP

Oil & Gas Refining & Marketing

37.21%

0.0%

OMC

Omnicom Group

Advertising Agencies

2.41%

32.7%

PDLI

PDL BioPharma

Biotechnology

7.93%

41.8%

PH

Parker Hannifin

Industrial Equipment & Components

1.96%

21.8%

QCOR

Questcor Pharmaceuticals

Biotechnology

2.98%

7.0%

ROK

Rockwell Automation

Industrial Electrical Equipment

2.34%

33.7%

RTN

Raytheon

Aerospace/Defense - Major Diversified

3.48%

32.6%

STJ

St. Jude Medical

Medical Appliances & Equipment

2.63%

37.5%

STX

Seagate Technology

Data Storage Devices

5.36%

12.6%

SWK

Stanley Black & Decker

Machine Tools & Accessories

2.75%

49.4%

SYK

Stryker

Medical Appliances & Equipment

1.94%

22.9%

TWX

Time Warner

Entertainment - Diversified

2.22%

38.3%

USMO

USA Mobility

Wireless Communications

4.51%

45.1%

VIAB

Viacom

CATV Systems

2.05%

23.8%

XLS

Exelis

Communication Equipment

3.65%

25.3%

Mean

4.02%

30.5%

Moreover, these stocks are reasonably priced:

Ticker

Company

P/E

P/S

P/B

ACN

Accenture

18.09

1.88

11.35

ADI

Analog Devices

19.38

4.61

2.99

BA

Boeing

13.16

0.71

7.42

BLC

Belo

7.93

0.97

2.4

CA

CA Technologies

11.18

2.13

1.88

CAH

Cardinal Health

12.86

0.13

2.23

COH

Coach

16.15

3.35

8.2

CSCO

Cisco Systems

12.47

2.2

1.95

CVX

Chevron

8.78

0.87

1.58

DELL

Dell

7.11

0.31

1.78

DLX

Deluxe

9.25

1.03

3.86

DMRC

Digimarc

17.47

3.06

2.64

DOV

Dover

13.76

1.35

2.2

EMR

Emerson Electric

18.97

1.51

3.58

GD

General Dynamics

10

0.73

1.66

HLF

Herbalife

12.06

1.3

13.6

HRB

H&R Block

14.99

1.74

5.67

INTC

Intel

8.8

1.87

2.04

JCOM

j2 Global

12.01

3.96

2.43

KLAC

KLA-Tencor

11.45

2.54

2.34

LMT

Lockheed Martin

10.49

0.63

12.19

MANT

ManTech International

8.72

0.35

0.8

MDT

Medtronic

13.68

2.64

2.51

MPC

Marathon Petroleum

8.09

0.25

1.79

MSFT

Microsoft

14.3

3.08

3.24

NSU

Nevsun Resources Ltd.

4.86

1.29

1.35

NTI

Northern Tier Energy LP

5.37

0.49

4.07

OMC

Omnicom Group

14.48

0.93

3.92

PDLI

PDL BioPharma

5.52

2.93

PH

Parker Hannifin

11.8

0.95

2.43

QCOR

Questcor Pharmaceuticals

10.28

3.7

12.84

ROK

Rockwell Automation

15.67

1.79

6.07

RTN

Raytheon

9.85

0.78

2.09

STJ

St. Jude Medical

14.63

1.95

2.32

STX

Seagate Technology

3.75

0.67

3.14

SWK

Stanley Black & Decker

20.82

1.09

1.68

SYK

Stryker

14.63

2.43

2.48

TWX

Time Warner

17.73

1.54

1.48

USMO

USA Mobility

5.68

1.07

0.93

VIAB

Viacom

12.25

1.94

3.65

XLS

Exelis

6.94

0.38

1.84

Mean

11.84

1.64

3.82

Median

12.01

1.35

2.43

Repurposing the Magic Formula for dividend investing created a compelling portfolio. Its median holding price-to-earnings ratio of 12.04, and a price-to-sales ratio of 1.43. This is an attractively valued income portfolio.

*These price multiples should be averaged using a harmonic mean (ratios which are better when they are smaller usually should be averaged using the harmonic mean) but reporting the median value and algebraic mean is more straightforward for a general audience.

Disclaimer: This article was written to provide investor information and education, and should not be construed as investment advice. I have no idea what your individual risk, time-horizon, and tax circumstances are: please seek the personal advice of a financial planner. This article uses third-party data and may contain approximations and errors. Please check estimates and data for yourself before investing.

Source: Magic Formula Dividends