Using the Magic Formula With Dividend Stocks

One advantage to Joel Greenblatt's Magic Formula strategy is its applicability to many other popular value based investing strategies. In this article, I'll show how an investor focused on building income through dividends can apply the MFI screen to find potentially attractive investments.

First, let's define what a dividend strategy is. Dividends are simply cash payments a company makes to its shareholders. This concept is exactly the same as interest paid on a savings account, or yield on a bond. The main difference is that dividend payments are up to the discretion of a company's management and board of directors. Dividends can be cut or raised at any time.

Investors following a dividend strategy are looking to maximize the amount of cash income generated by their portfolio. In essence, a sizable portfolio can throw off enough in cash dividends to replace the income from a job! These investors are looking for a few things. One, a healthy dividend yield, usually 3% or higher. Two, a company that has reliable cash flows so that the likelihood of a dividend cut is minimal. Three, companies with a history of regular dividend increases and no dividend cuts. Usually, once this investment is found, the dividend investor will re-invest dividend payments into buying more shares of stock. By doing this, they receive increasing amounts of income due to two things: (1) more shares due to re-invested dividends and (2) more dividends on each share due to dividend hikes.

To illustrate the viability of this plan, let's take a look at a current Magic Formula stock paying a solid and sustainable dividend: Sherwin-Williams (SHW). Let's say we purchased Sherwin-Williams back in 2000 when it's dividend yield was about 2.75%. This company had a 20 year history of dividend hikes at the time, and predictably has continued to raise it's dividend every year. By reinvesting those payments, our yield steadily rose, and the effects of compounding accelerated until today Sherwin-Williams would be paying us nearly 8% on our original investment this year:

Assuming we continued this strategy, it is likely that this yield will continue to exponentially increase, so that by the time retirement rolls around (say, 20 years), our original investment could very well be paying us 50% of it's value, or more, annually, money that can go towards replacing working income.

So, how does the Magic Formula screen play into this? Well, the Magic Formula by design turns up stocks selling at very cheap prices relative to earnings. Often, this also means very cheap prices relative to dividend yields. Add this to the screen's design to find good companies (i.e. companies that can sustain a dividend), and you have a fertile field for potential income investments. Have a look at some current MFI dividend payers:

Stock	Current Dividend Yield
Biovail Corporation (BVF)	15.2%
Gannett Company (GCI)	9.2%
Pfizer (PFE)	6.9%
Ambassador's Group (EPAX)	3.3%
Sherwin Williams (SHW)	2.9%

If Sherwin-Williams can build up to an 8% yield from a 2.75% start in 8 years, imagine what starting at a 15% yield could build to!

Of course, there is one other matter. These dividend payers must also have cash flows that can sustain these payouts. We also need to make sure that the company has a history of continually increasing dividends. This is where MagicDiligence comes in. By analyzing the cash flows and management histories of these dividend payers, we can find those MFI stocks most likely to deliver continually rising income from an investment.

Dividend strategies can be extremely attractive for very long term holders of stock. Does retiring on income from investments without even touching the principal sound attractive to you? Take a free trial today and find some great potential income generating investments.

Disclosure: Steve owns SHW, PFE

Comments

[David Tsao]

A good angle. I'm currently testing his system, but at times I throw other filters on top of it (like PEG < 1, etc.), and run this picks through a DCF analysis.

Now's a good time for these types of screens.

[BlueOkie]

I think PEG < 1 is a good idea! The problem is what values do you use for P E and G? Do you use current price or future price. Current E, TTM E or future E. Where do you get G from?

[WACG]

For those that are interested the so called "magic" formula is:

Formula
Establish a minimum market capitalization (usually greater than $50 million).
Exclude utility and financial stocks
Exclude foreign companies (American Depositary Receipts)
Determine company's earnings yield = EBIT / enterprise value.
Determine company's return on capital = EBIT / (Net fixed assets + working capital)
Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over a 12-month period.
Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
Continue over long-term (3-5 year) period

DUH!

[notsosmart]

this is a new world in finance. be careful using old traditional formulas,charts,graphs... at the moment can fool you as the future of some co,s could be in doubt.try to think for yourself as everybody has an agenda & nobody is held accountable for much especially lying.

[The hand]

Notsosmart is "Verysmart". In my view, we are going through a major fundamental realignment of the world economy in which the USA is becoming less and less dominant daily. Combine this with a USA home grown credit crisis which it feed to the world and you have some pretty nasty sh** happening. These well documented formulas may be inoperative.

[oldtrdr]

I have a small problem with not including foreign securities, because of changing macro trends, and a bearish view of the dollar, long-term. I will say that one "problem" with foreign securities, is that they normally don't pay quarterly (semi-annually, or annually is more the rule) dividends; in the case of semi payers, the payments aren't equal (usually weighted, with one "chunk" being substantially larger than the other). This seems to be because foreign cos. normally anonounce a "percentage" of profits to be paid, rather than a specific monetary figure. All of these things can lead to a "lumpy" income stream.

old trader

[MD]

Every time in the past someone has said "we're going through a fundamental change", they've been wrong. It was said during the tech boom. It was said in the late 80's when Japan was booming. It was said in the 70's after 7 years of stagflation. It was certainly said in the 1930's. And guess what? Value investing has always been a winner. Don't be fooled by the gushing talking heads. Buying cheap and selling dear will ALWAYS work.

[investorslive]

EPAX mentioned here

www.investorslive.com/.../