Since interest rates remain low as we start 2013, investors should be concerned about overpaying for yield. 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 today.
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 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, they typically report 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.
Even more interesting, 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 either a $50 million, $2 billion, or $10 billion market capitalization minimum.
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:
Broadcasting - TV
Networking & Communication
Apparel Footwear & Accessories
Scientific & Technical Instruments
Drug Related Products
Semiconductor - Broad Line
Internet Software & Services
Semiconductor Equipment & Materials
Security Software & Services
Medical Laboratories & Research
Data Storage Devices
The Interpublic Group
Entertainment - Diversified
Moreover, these stocks are reasonably priced:
The Interpublic Group
Repurposing the Magic Formula for dividend investing created a compelling portfolio. Its got a median holding price-to-earnings ratio of 10.62, and a price-to-sales ratio of 1.13. 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.