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For DIY investors, the usage of stock screeners is probably the first step in an investment process. Stock screeners are the perfect tool to save time and build a solid list of dividend stocks to pick from. A while ago, I covered the best free stock screeners along with a short tutorial on how to use them.

Unfortunately, stock screeners are not perfect either. A good understanding of their system and flaws will help you pick the right dividend stocks for your portfolio. But if you are trigger happy and take the first results from your screener, you might end-up with some real problems!

Metrics to be Used for an Effective Stock Screener

The purpose of using a stock screener is to reduce your stock research span to a few stocks. Therefore, you should not hesitate to be picky with your first search; add as many metrics as possible. If your screeners generate only a dozen stocks and you are currently looking to buy only one or two, you have done a great job. On the other hand, if you start your research with over 100 stocks, you are missing the main advantage of your stock screener which is to save some time!

The point is to determine what you are looking for before starting your research.

Are you looking for a Dividend Aristocrat with a long dividend payout history?

Are you ready to sacrifice dividend growth for an immediate high yield over 5%?

Are you looking to invest in a specific sector to gain momentum or hedge your portfolio?

Are you looking for a stock that will be part of your portfolio for the next 15 years?

Depending on what you are looking for, metrics entered as filters will vary greatly. Here's how I would use a stock screener to answer the four previously mentioned questions:

#1 Dividend Aristocrats:

Simply go check the Dividend Aristocrats Lists or the Canadian Aristocrats List. You don't need to use rocket science to find companies that have been increasing their dividend payout for the past 25 years in a row. This list exists as is for the U.S. market and there is a slightly different definition for Canadian stocks. Still, both lists will do the work if this is what you are looking for.

#2 High Dividend Yield:

  1. Dividend yield over 5%
  2. Positive sales growth over the past 5 years
  3. Positive EPS growth over the past 5 years

The point here is to find high paying dividend stocks that will continue to pay its distribution. At one point in 2012, you could have bought RadioShack (RSK) at a 9% dividend yield. But the thing is that RSK didn't increase its payout through the roof - the stock plummeted that year due to bad financial results. Within months, RSK cut its dividend payouts and the yield is now… well…. ZERO!

#3 Specific Sector

This is where using a stock screener can get tricky. Believe it or not, sectors and industries vary greatly from one stock screener to another. I'm not sure I can explain why reputable financial websites can't get along with each other and have different classifications, if you run a sector filter analysis using Yahoo Finance, Google Finance, Fin Viz and Bloomberg, you will find different results!

My advice for investors who are looking to pick a specific sector would be to run different screeners at first to see which stocks are on all lists. Then, you copy and paste your results in an Excel spreadsheet. You isolate stocks that are not on all lists to make sure they belong to your definition of this sector. Then, you can delete duplication entries and get a fresh list that will cover the whole sector.

#4 Stocks You Want to Hold Forever

I like to believe that a part of my portfolio will remain the same for the next 15, 25 or 50 years. This is the "core" of my portfolio. These companies must be really strong and offer a unique advantage for future growth. They are close to the Warren Buffett investment model. For example, I truly believe that Coca-Cola (NYSE:KO) will continue its business activities until I retire in 33 years.

This is also probably where the metrics used to find these stocks will be the most different from one investor to another. I use the following metrics to start my stock screener:

  • 5 Year Annual Income Growth Rate: between 1 and 100 (if sales don't go up, dividend growth will eventually be jeopardized).
  • Current Dividend Yield: over 3% (I think 3% is reasonable in the current economy. I sometimes cheat and look for over 3% in the hope of picking a gem with a 2.75% dividend yield).
  • Payout Ratio: Under 80% (you want the company to be able to continue paying its distribution even through a rough period)
  • Return on Equity: Over 10% (I want companies that use my money to create wealth. Keep in mind that you'll need to look inside each financial statement to see if the ROE is stable over the years).
  • 5 Year Annual Dividend Growth Rate: Over 1% (I know I've told you that we are looking at double digit dividend growth but the crisis in 2008 has produced some statistical anomalies as several companies stopped their dividend growth approach during that period)
  • Current Price Earnings Ratio: Under 15 (I'm looking at companies that are undervalued. Since the average P/E ratio of the market is historically around 15, it's a good start. I sometimes cheat and put in 20 when I don't get what I'm looking for)

Flaws with Stock Screeners and the Metrics You Use

I don't know if you have noticed, but there are several flaws coming out of any result from a stock screener. Some definition (like sectors) are not the same from one site to another, some numbers are not calculated the same way and sometimes the market is playing around with these metrics. But if you are aware of them, you can compensate and dig a little further.

#1 Definition & Calculation methods

Besides the sector definition, you have to pay attention to the definition of several financial concepts. The most common problem is with the dividend payout ratio. The calculation of the earnings per shares can greatly differ from one website to another.

For example, you can use a TTM (total trailing month) EPS, the past year EPS, the forward EPS and then decide to include or exclude special events that happened during that year. This is why it's important to understand which data your screeners are using before pulling out the search. As long as we are clear about what we want and don't want to use, using free stock screeners shouldn't be a problem.

#2 Current Stock Market Fooling Around with Screeners Data

Another problem that most investors seem to forget when they pull out searches from screeners is the current state of the market. Do you think that many companies were showing sales or earnings growth in 2009 after the crash of 2008? The truth is that most companies suffered from the recession. Dividend increases were rare and sales & earnings growth were exceptional.

You should be able to adjust your metrics according to the current market. The problem that we are currently seeing on the market is about valuation. Since we are in the middle of a bullish market, the P/E ratio is flying up. From an overall market priced at 13 times the earnings back in early 2009, we are now close to 17 times.

Therefore, if you look at stocks with a P/E ratio under 15, you won't be finding many companies to invest in. And these companies are probably not showing strong growth potential in the future. On the other hand, you don't want to buy stocks too high. You would be stuck with an overpriced / underperforming stock in your portfolio for a while.

A good compromise would probably be to use a P/E of 17 or 18 to pick stocks that are following the market and are not seated in the first row of the market rollercoaster.

You Are Not Over Once You Get Your Search Results

I think the best example I can pull out is my pick for RSK in 2012 as one of my best dividend stocks for the year. Each year around this time of the season, I pull out a stock screener to build my list of the best dividend stocks for the upcoming year. I've done this in 2012 and 2013 (and going to publish another book in 2014 since I've beat the market in the past 2 years).

But I took one wrong bet two years ago when I picked RSK. The previous 5 years' metrics were good, so the company appeared in my stock screener results. I took the bet RSK would continue to show strong results and that its strategy would continue to work well… hum…Ah! This is why you always have to dig further into your small list of stocks and look at the companies' financial statements before making an investment decision.

Source: Don't Take Your Screeners Too Seriously