Good dividend yield, low payout ratio, consistent dividend growth and low debt with significant free cash flow are a good combination for long term dividend stocks strategy.
I tried to create such a strategy that can outperform the market by a big margin. The following screen shows such promise. I have searched for companies that are included in the Russell 1000 index with a decent dividend yield with a low payout ratio and low debt that consistently have raised dividend payments and have a low price-to-free-cash-flow ratio. Many investors prefer using free cash flow instead of net income to measure a company's financial performance because free cash flow is more difficult to manipulate. Free cash flow is the operating cash flow minus capital expenditure.
Russell 1000 Index
The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market.
The screen's method requires all stocks to comply with all following demands:
- Dividend yield is greater than 2.00%.
- The payout ratio is less than 75%.
- The annual rate of dividend growth over the past five years is greater than 5.0%
- The price to free cash flow is less than 20.
- The debt-to-equity ratio is less than 0.60.
- The 10 stocks with the lowest payout ratio among all the stocks that complied with the first five demands.
I used the Portfolio123's powerful screener to perform the search and to run back-tests. Nonetheless, the screening method should only serve as a basis for further research. All the data for this article were taken from Portfolio123.
After running this screen on May 22, 2013, before the market open, I discovered the following ten stocks: AFLAC Inc (NYSE:AFL), PartnerRe Ltd. (NYSE:PRE), AXIS Capital Holdings Ltd (NYSE:AXS), ACE Ltd (NYSE:ACE), Northrop Grumman Corp (NYSE:NOC), Travelers Companies Inc (NYSE:TRV), CNA Financial Corp (NYSE:CNA), TE Connectivity Ltd (NYSE:TEL), Raytheon Co. (NYSE:RTN) andHollyFrontier Corp (NYSE:HFC).
The table below presents the ten companies, their last price, their market cap and their industry.
The table below presents the dividend yield, the payout ratio, the annual rate of dividend growth over the past five years, the price to free cash flow, the debt-to-equity ratio and the PEG ratio for the ten companies.
In order to find out how such a screening formula would have performed during the last year, last 5 years and last 14 years, I ran the back-tests, which are available by the Portfolio123's screener.
The back-test takes into account running the screen every four weeks and replacing the stocks that no longer comply with the screening requirement with other stocks that comply with the requirement. The theoretical return is calculated in comparison to the benchmark (S&P 500), considering 0.25% slippage for each trade and 1.5% annual carry cost (broker cost). The back-tests results are shown in the charts and the tables below.
One year back-test
Just a matter of curiosity, the table below presents the ten companies originated by the screen formula one year before, on May 21, 2012.
Five years back-test
The table below presents the ten companies originated by the screen formula five years before, on May 21, 2008.
Fourteen years back-test
The table below presents the ten companies originated by the screen formula fourteen years before, on September 11, 1999.
The Russell 1000 dividend stocks screen has given much better returns during the last year, the last five years and the last 14 years than the S&P 500 benchmark. The Sharpe ratio, which measures the ratio of reward to risk, was also much better in all the three tests. One year return of the screen was exceptionally high at 47.36% while the return of the S&P 500 index during the same period was at 26.86%. The difference between the Russell 1000 good-yielding screen to the S&P 500 benchmark was much more noticeable in the 14 years back-test. The 14-year average annual return of the screen was at 15.19% while the average annual return of the S&P 500 index during the same period was only 2.15%. Although this screening system has given superior results, I recommend readers use this list of stocks as a basis for further research.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.