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The Potency Score System is a stock rating methodology designed for dividend growth stocks. The monthly stock lists have been published here since last October and you can see the first performance update of the system's top picks here: Performance Results. The methodology utilizes a multitude of fundamental data and essential metrics and their interrelations to calculate and assign a Potency Score to each dividend stock, thereby producing a ranked list of stocks. Empirical data as well as theoretical concepts with proven predictive value have been applied throughout the system.

The Potency Score (PS) is a measure of the long term dividend return potential of a company. It encapsulates a company's most important fundamental metrics into a score, allowing easy comparison between stocks. The higher the score, the better the odds of higher long term dividend returns. A good way to get a feel for the Potency Score is to view it as a relative forecast of a stock's seven-year yield-on-cost.

The system's picks tend to be companies that have been paying dividends for many consecutive years and consistently increasing it. Since sustaining and growing dividends requires earnings growth, these companies tend to produce respectable capital gains as well.

The system's methodology has been continuously evolving and has come a long way since its initial version.

This month's list of stocks with the highest Potency Scores is the product of the new version 5.2.

For those who prefer a less hands-on investment approach I have published another equities investment strategy using Exchange Traded Funds (ETFs) instead of individual stocks, here: The Immortal Portfolio,

New System Enhancements

Other than some fine tuning and refining of a few parameter weightings and calculations there are no major changes in version 5.2 vs. V5.0.

The Metrics

The Potency Score System (version 5.2) utilizes the following metrics, both individually as well as in combinations with other variables.

  • Current Dividend Yield
  • Dividend Growth Rate (DGR) for 1-, 3-, 5-, and 10-year periods
  • Dividend to Free Cash Flow Ratio (trailing twelve months [ttm] and 5-year average)
  • Return on Equity (ROE) (ttm and 5-year average)
  • Return on Assets (ROA) (ttm and 5-year average)
  • Revenue Growth (1-year and 3-year)
  • Projected annual Earnings per Share [EPS] growth rate for the next five years
  • Payout Ratio
  • P/E Ratio (ttm, Forward, and 5-year average)
  • Price to Cash Flow (1-year and 3-year)
  • Debt to Equity Ratio
  • Years of consecutive dividend growth

Other metrics are under study and examination and may be introduced in future versions of the System.

Sources of data - The data come from various public financial sources, including Yahoo Finance, Google Finance, Fidelity Investments, TD Ameritrade, Morningstar, etc. The four DGRs for 1-, 3-, 5-, and 10-year periods and the $dividend amount come from CCC List. I have tried to use the most reliable sources, and when data was unavailable at one source I have tried to obtain it from another.

Metric Selection

In the initial version of the system I started out pure, utilizing only five metrics to calculate the PS. The results were satisfactory and at first I was of the belief that combining too many variables might have a counter productive effect as one variable could cancel out another one. But as I delved deeper and deeper into the methodology I have come to the conclusion that chosen properly, more metrics produce vastly superior and more reliable results. For this reason, the utilized metrics have grown to the list given above.

Every metric gives the perspective of a company from a different angle, and the more angles you look at, the better the overall picture of the company you will get. The fact is, companies can get very creative with their reporting and can present certain metrics much more favorably than they actually are - EPS being a notorious example, as it's a highly followed metric - and they can do that for a long time. But they can not misrepresent too many essential metrics for long. So, I have tried to choose the metrics methodically for maximum effectiveness. In addition I have attempted as much as possible to fine-tune the variables' weightings to correspond to their real-life effects and to minimize correlations.

Methodology Overview

In order to figure out the amount of dividends returned by a company over the long term, we need to know its dividend growth rate (DGR) in advance. Unfortunately my crystal ball fogged out a long time ago, so we have to make intelligent forecasts based on the company's past and current behavior and performance plus its future growth potentials. Public companies regularly give out lots of information on the financials of their business and its performance. The key is utilizing this data in such a way to maximize the accuracy of our forecasts.

The easiest way to forecast a company's future DGR is to simply adopt its 10-year or the 5-year DGR and assume the company will continue to do the way it has in the past. But more often than not this would produce erroneous results since it ignores the realities of the evolution of a company's business, its growth and profitability trends, and its dividend growth trend. So, through PS methodology I aspire to improve on this by sifting through the companies' historical and current data plus their expected revenue and earnings growth projections.

The score calculation process starts with the four dividend growth rates for the past 1-, 3-, 5-, and 10-year periods. Abnormally high DGRs are smoothed out and the four DGRs are weighted and combined to produce a normalized DGR.

Next, over a dozen company metrics are scrutinized and each metric, through various formulas, adds to or subtracts some weighted amount from the normalized DGR. The final result is the adjusted normalized DGR. Then this value along with the current dividend yield are used to calculate the Potency Score, which can be looked at as a relative forecast of a stock's seven-year yield-on-cost.

In the first versions of the score I used four times a year compounding of the dividends but starting with the January list the calculations are based on twice a year compounding.

And finally, here are the top 25 stocks for this month. To see the rest of the list please see my blog.

Top Stocks For March

Data as of close Friday, 03/02/2012

Symbol

$ Price

Potency
Score

%Div
Yield

[fwd]

%ROA [ttm]

P/E
Ratio
[fwd]

%Div /
FCF

[ttm]

% Payout
Ratio
[ttm]

BBL

64.16

28.48

3.43

22.98

7.54

38.00

23.73

LMT

88.50

27.45

4.52

7.00

11.29

37.81

41.40

AZN

44.89

26.69

6.24

14.35

6.18

53.38

37.21

ARLP

71.71

26.65

5.52

17.51

8.65

57.93

44.62

INTC

26.92

26.40

3.12

18.20

11.60

41.14

32.74

NVS

54.02

26.35

4.55

7.76

14.29

49.66

52.81

STRA

99.74

25.07

4.01

45.88

14.54

37.93

45.05

AHGP

50.92

24.12

5.01

12.35

6.17

60.05

63.55

DX

9.34

22.51

11.99

1.00

9.25

n/a

106.55

WAG

32.69

21.51

2.75

9.89

11.84

40.78

27.15

NVO

141.45

20.22

1.75

23.46

4.96

7.61

25.04

ACN

59.60

19.90

2.27

14.48

18.45

27.59

34.85

EOC

53.22

19.52

3.89

8.84

0.03

0.14

n/a

TEVA

45.25

18.60

2.37

5.50

14.64

30.72

25.40

MSFT

32.08

18.46

2.49

21.30

11.88

25.10

24.67

RCI

38.57

18.37

4.10

8.51

13.49

51.80

49.65

MDP

32.66

18.10

4.68

7.44

12.51

44.67

44.34

NTT

23.66

17.78

3.48

2.59

0.15

0.24

38.12

DCM

17.11

16.96

4.02

7.22

0.16

0.51

23.19

RTN

51.37

16.52

3.35

7.22

10.25

35.01

32.58

HAS

35.21

16.19

4.09

9.33

11.25

62.44

40.78

HRS

43.79

15.87

3.01

9.53

8.86

39.29

24.29

COP

77.65

15.72

3.40

8.12

9.28

52.95

29.43

MDT

37.91

15.61

2.56

10.18

10.96

27.57

29.53

GES

35.08

15.43

2.28

17.17

11.39

32.19

27.02

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The table columns are: Stock symbol, $Price, Potency Score (Ver. 5.2), %Dividend Yield (forward), %Return on assets (trailing twelve months [ttm]), Price to earnings ratio (forward), %Dividend to free cash flow ratio [ttm], %Payout ratio [ttm].

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Source: Top Dividend Growth Stocks Ranked By Potency Score For March

Additional disclosure: I may initiate a long position in any of the stocks discussed over the next 72 hours.