Out of the nearly 8,900 companies in the Reuters.com stock universe, a total of 48 recently appeared on the Income Stocks screen. (Click here to download an Excel sheet comparing these 48 companies.)
The Income Stocks screen looks for dividend-paying companies that have increased the amount doled out to shareholders at clips that are faster than the respective industry averages over the last three years. Of course, we would also like to see some sign that this rate of outperformance has not faded, so we filter for companies where the year-over-year dividend growth is also above the industry norm. This reduced our list to 26 names, but closer scrutiny whittled down the field.
To steer away from the political, economic and currency risks associated with shares of foreign firms, we eliminated American Depositary Receipts (ADRs), which are baskets of stocks of foreign companies that trade on U.S. exchanges like those of domestic companies. This reduced the list to 19 U.S.-domiciled firms.
The screen does not include any variables for valuation. This is important to note given the recent rally in the U.S. equity markets. After all, given the run-up, there is a chance that stocks will reach lofty valuations, which might leave them more susceptible to losses in the event of a downturn.
That said, we wanted to filter for companies with reasonable valuations. Our first step in this direction involved identifying companies that have price to earnings (P/E) ratios - based on trailing 12-month [TTM] earnings per share [EPS] - that are less than the average of their respective industries. At this point, 12 companies remained.
Of course, simply because a company's P/E is below its industry average does not necessarily mean that it is priced at an attractive valuation. After all, the firm could have just come off a banner year, but earnings next year are expected to plummet and this expectation has dragged on the stock. In this case, we see the lower price against the high earnings, giving rise to a low P/E ratio and creating the impression that the stock is trading at an appealing valuation. Thus, we also take into consideration the forward P/E - the current stock price relative to expected earnings.
We divide the forward P/E by the long-term EPS growth rate to arrive at the PEG ratio. Although more-conservative investors typically favor companies with PEG ratios below 1.00, numbers a bit higher are still reasonable. We filtered out companies with PEG ratios above 2.00. We also excluded firms where we could not calculate the PEG ratio. Here we have six companies.
We also want companies that are improving their earnings. Thus, we focus on firms where EPS growth in the most recent quarter [MRQ] beat the industry average. This left us with two companies.
Finally, keeping in mind that we are looking at income stocks, we turned to dividend yield and payout ratio. The Income Stocks screen starts off by requiring that a stock have a dividend yield in excess of 2 percent. As indicated below, both Community Trust Bancorp and Ethan Allen Interiors Inc. (ETH) cleared this hurdle. But the screen does not make any yield comparison against the industry. Thus, we filtered for the firm where the dividend yield was greater than the industry average. This is where Community Trust Bancorp pulled ahead.
Learn about Dividend Ratios
The Income Stocks screen also requires that a company's dividend growth rate must be at least 10 percent above the industry average. Although both companies meet this requirement, as displayed above, Ethan Allen clearly has the advantage here. Thus, before we settled on Community Trust Bancorp, we wanted to perform a test to support our decision.
The Income Stocks screen also looks at the payout ratio - that portion of net income that is granted to shareholders in the form of dividends. The issue with the payout ratio is that a figure too high could crimp the company's operations, let alone its growth. To steer clear of companies that are paying out a high level to shareholders, the screen requires that a company's TTM payout ratio must be no more than 25 percent above the industry average. As shown above, the payout ratios for both firms are not too distant from their respective industry norms. But this does not tell us anything about the consistency of the company's earnings or the payout ratios. We then looked for the firm with the most consistent payout ratios over the last several years.
As indicated above, Community Trust Bancorp's payout ratio has a much narrower range, thus cementing our focus on this Kentucky-based regional bank.
At the time of publication, Erik Dellith did not own shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.
Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.