How To Pick The Best Dividend Stocks (Part 1): Setting Up The Initial Screen

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Includes: JNJ, MO, PEP
by: Parsimony Investment Research

Summary

Most investors fail to succeed because they either do not have a plan or they do not have the discipline to stick to their plan.

A proper stock selection process is critical to long-term investing success.

We believe that investors should deploy a structured and quantitative methodology for screening dividend stocks.

The Importance of a Proper Investment Plan

Most "do-it-yourself" investors fail miserably over the long-term. As a matter of fact, the majority of professional investors fail to beat the returns of the broader market indices every year. That said, there is one common trait that every successful investor shares…an investment plan!

Unfortunately, simply setting up an investment plan isn't enough to succeed these days. You also have to have the discipline to carry out that plan (come rain or shine). Contrary to popular belief, the market does not control your investment success…you do!

While the specific details of a dividend investor's personal investment plan will vary based age, risk tolerance, etc., all investment plans should have a strategy in place for selecting stocks.

Over the next 5 articles, we will dig deeper into our stock selection process. Specifically, we will highlight the four main categories of our new dividend stock ranking system: (1) Dividend, (2) Safety, (3) Value, and (4) Momentum. However, first we will talk about the screening process that we use to narrow the field of dividend stocks into our coverage universe of approximately 500 stocks. Please make sure to "follow" us so that you can read the whole series.

Ranking System Overview

We use a combination of fundamental and technical analysis to determine which stocks to buy and when to buy them. For dividend stocks in particular, we have a proprietary rating system that ranks over 500 U.S. dividend stocks on a weekly basis.

Our ratings are derived by ranking each stock based on 30 key fundamental and technical data points across four rating categories:

  1. DIVIDEND - Measures the stock's historical dividend stability and growth and the company's ability to continue to make (or raise) its current dividend (e.g., current yield, consecutive years with dividend increases, dividend growth rates, payout ratio).
  2. SAFETY - Measures the stock's overall financial health (e.g., sales, EPS, and cash flow growth, ROC, leverage, historical volatility, beta). All else being equal, companies with stable revenues, earnings and cash flow and strong balance sheets tend to be safer investments with more stable dividend growth.
  3. VALUE - Measures the stock's relative valuation compared to historical trading levels (e.g., P/Sales, P/E, P/B, EV/EBITDA, shareholder yield). We use multiple valuation metrics to derive our Value rating as multi-factor models have proven to be better indicators of long-term value than single-factor models.
  4. MOMENTUM - Measures the strength of the stock's trend (e.g., 6-month and 12-month relative strength, moving average trends, industry relative strength). Stocks that outperform tend to continue to outperform.
Identifying the Right "Field" of Dividend Stocks To Analyze

There are literally thousands of stocks out there that pay dividends. However, all of these stocks (and dividend streams) are not created equal.

Most online brokers offer their clients stock screening software for free. Investors can often utilize this software to determine which dividend stocks are even worth doing additional research on.

Before we analyze a single data point for a stock, we first go through a simple screening process that significantly narrows the field. Below are the metrics we focus on for our initial screen:

  • U.S. based companies that trade on major U.S. exchanges
  • Reporting History: > 5 years
  • Market Capitalization: > $500 million
  • 3-Month Avg. Daily Volume: > 250,000 shares
  • Stock Price: > $10.00
  • Dividend Yield: > 1.0%
  • Dividend History: minimum of 3 consecutive years of dividend increases or minimum of 5 consecutive years of no dividend cuts.

We chose these metrics because ultimately we only want to invest in stable companies that we feel will pay solid dividends for years to come. In addition, our ranking system is very quantitative in nature which requires a minimum operating history that we can analyze. The longer the history, the better...and the more relevant our analysis will be.

This simple screen narrowed our coverage universe to approximately 500 stocks, which is a much more manageable sample size to run through our ranking system process. The beauty of a stock screen is that it usually includes alot of names that you know and love (e.g., PepsiCo (NYSE:PEP), Johnson & Johnson (NYSE:JNJ), Altria Group (NYSE:MO))...but it also includes some pleasant surprises that you may not have considered otherwise (stay tuned to the next 4 parts of the series for details).

Summary

To avoid getting overwhelmed by a stock "picking" process, dividend investors should first consider running some initial stock screens to help narrow the field of candidates.

The next four parts of this series will dig into the meat of our dividend stock ranking system and will include specific dividend stocks that rate highly across each of our four main rating categories. Please make sure to "follow" us so that you can read the whole series.

Disclosure: The author is long JNJ, MO, PEP.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.