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Good dividend yield, low payout ratio, consistent dividend growth and low debt with significant earnings growth are a potent combination for long-term dividend stocks strategy.

I tried to create a small-cap dividend portfolio 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 2000 index with a healthy dividend yield with a low payout ratio and low debt that consistently have raised dividend payments and have had decent annual earnings growth for the past 5 years.

Russell 2000 Index

Description from Russell Investments:

The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.

The screen's method requires all stocks to comply with all following demands:

  1. Dividend yield is greater than 3%.
  2. The payout ratio is less than 100%.
  3. The annual rate of dividend growth over the past three years is greater than zero.
  4. Average annual earnings growth for the past 5 years is greater than 5%.
  5. The debt to equity is less than 0.50.
  6. The five 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 29, 2013, before the market open, I discovered the following five stocks: Horace Mann Educators Corporation (NYSE:HMN), First Financial Corp. (NASDAQ:THFF), Ames National Corp. (NASDAQ:ATLO), National Bankshares Inc. (NASDAQ:NKSH) and Citizens & Northern Corp. (NASDAQ:CZNC).

The table below presents the five companies, their last price, their market cap and their industry.

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The table below presents the dividend yield, the payout ratio, the annual rate of dividend growth over the past three years, the trailing P/E, the average annual earnings growth for the past 5 years, and the debt-to-equity ratio for the five companies.

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Horace Mann Educators Corporation

Horace Mann Educators Corporation, through its subsidiaries, operates as a multiline insurance company in the United States.

On April 24, Horace Mann Educators reported its first quarter 2013 financial results. In the report, Horace Mann's President and CEO Peter H. Heckman said:

Horace Mann's first quarter operating income was $0.55 per share -- consistent with our expectations, and a solid start for the year. In property and casualty, while the combined ratio was higher compared to first quarter 2012, both written and earned premiums increased, retention ratios improved, catastrophe losses were modest and prior years' reserves continued to develop favorably. In our annuity business, assets under management were up 9% over prior year, more than offsetting the impact of modest spread compression, and earnings benefited from another quarter of positive deferred policy acquisition cost unlocking. And, in our life segment, first quarter sales of Horace Mann products increased 28% compared to a year earlier, while earnings were negatively impacted by higher -- but more typical -- mortality losses.

The HMN stock price is 7.52% above its 20-day simple moving average, 10.53% above its 50-day simple moving average and 22.19% above its 200-day simple moving average. That indicates a short-term, mid-term and long-term uptrend.

HMN Dividend Chart

HMN Dividend data by YCharts

First Financial Corp.

First Financial Corporation, through its subsidiaries, provides financial services. Its services include commercial, mortgage, and consumer lending; lease financing; trust account services; depositor services; and insurance services.

On April 29, First Financial reported its first quarter 2013 financial results. Net income increased 3.4% to $7.7 million compared to $7.4 million for the same period of 2012. Return on assets for the three months ended March 31, 2013 was 1.05% compared to 1.02% for the three months ended March 31, 2012. Book value per share was $28.43 at March 31, 2013, a 6.05% increase from the $26.81 at March 31, 2012. Shareholders' equity increased 6.6% to $378.4 million from $354.9 million on March 31, 2012.

The THFF stock price is 0.67% above its 20-day simple moving average, 0.81% above its 50-day simple moving average and 2.07% above its 200-day simple moving average. That indicates a short-term, mid-term and long-term uptrend.

THFF Dividend Chart

THFF Dividend data by YCharts

Ames National Corp.

Ames National Corporation operates as a bank holding company for First National Bank that provides commercial banking services primarily within the central Iowa counties of Boone, Marshall, Polk, and Story.

The ATLO stock price is 1.40% above its 20-day simple moving average, 2.87% above its 50-day simple moving average and 1.14% above its 200-day simple moving average. That indicates a short-term, mid-term and long-term uptrend.

ATLO Dividend Chart

ATLO Dividend data by YCharts

National Bankshares Inc.

National Bankshares, Inc. operates as the bank holding company for the National Bank of Blacksburg, which provides a range of retail and commercial banking services to individuals, businesses, non-profits, and local governments in Virginia.

On April 18, National Bankshares reported its first quarter 2013 financial results. Net income was $4.22 million for the quarter ended March 31, 2013. Basic net income per share was $0.61. The return on average assets for the first quarter was 1.56% and the return on average equity was 11.26%. At March 31, 2013, the Company had total assets of $1.10 billion, an increase of 1.35% when compared to the end of the first quarter of 2012. In the report, National Bankshares' Chairman, President & CEO James G. Rakes commented:

During the first quarter of 2013, we were faced with the continued compression of the net interest margin and soft loan demand, but we still are delivering a strong financial performance for our stockholders. Although total loans at quarter-end, almost $574.96 million, were down slightly from the total of $584.56 million at the end of March last year, our returns on assets and equity compare favorably among peer financial institutions.

The NKSH stock price is 1.80% above its 20-day simple moving average, 1.83% above its 50-day simple moving average and 5.85% above its 200-day simple moving average. That indicates a short-term, mid-term and long-term uptrend.

NKSH Dividend Chart

NKSH Dividend data by YCharts

Citizens & Northern Corp.

Citizens & Northern Corporation operates as the bank holding company for Citizens & Northern Bank that provides various banking and mortgage services to individual and corporate customers in north central Pennsylvania and southern New York.

On May 09, Citizens & Northern reported its first quarter 2013 financial results. Net income was $4,706,000 or $0.38 per basic and diluted share in the first quarter 2013, representing an annualized return on average assets of 1.50% and an annualized return on average equity of 10.31%. Net income in the first quarter 2013 was down from $5,939,000 ($0.48 per share) in the fourth quarter 2012 and $5,587,000 ($0.46 per share) in the first quarter 2012.

The CZNC stock price is 1.26% above its 20-day simple moving average, 2.52% above its 50-day simple moving average and 5.49% above its 200-day simple moving average. That indicates a short-term, mid-term and long-term uptrend.

CZNC Dividend Chart

CZNC Dividend data by YCharts

Back-testing

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 benchmarks (S&P 500 and Russell 2000), 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

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Just a matter of curiosity, the table below presents the five companies originated by the screen formula one year before, on May 26, 2012.

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Five years back-test

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The table below presents the five companies originated by the screen formula five years before, on May 28, 2008.

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Fourteen years back-test

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The table below presents the five companies originated by the screen formula fourteen years before, on January 02, 1999.

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Summary

The Russell 2000 good-yielding screen has given much better returns during the last year, the last five years and the last 14 years than the S&P 500 and Russell 2000 benchmarks. The Sharpe ratio, which measures the ratio of reward to risk, was also much better in the five and fourteen year's tests. One-year return of the screen was at 30.36% while the return of the S&P 500 index during the same period was at 25.13%, and the return of the Russell 2000 was at 28.90%. The difference between the Russell 2000 good-yielding screen to the S&P 500 and Russell 2000 benchmarks was much more noticeable in the 14 years back-test. The 14-year average annual return of the screen was at 11.66% while the average annual return of the S&P 500 index during the same period was only 2.11%, and the return of the Russell 2000 was at 6.16%. Although this screening system has given superior results, I recommend readers use this list of stocks as a basis for further research.

Source: Russell 2000 High-Yielding Dividend Portfolio That Has Outperformed By A Big Margin