The S&P 500 is currently trading for a price-to-earnings ratio of 24.6. Its historical average is 15.6.
The market is clearly overvalued on a historical basis today. Ultra-low interest rates have artificially inflated real asset prices.
This might be good news for overleveraged investors looking for a quick buck. It is bad news for long-term investors looking to buy into great businesses at a discount.
It's important to remember, this is a market of stocks, not a stock market. That means there are still bargains to be found among individual stocks, but buying a market indices in aggregate is a sure way to expose yourself to overvalued securities.
But that leads to the question… How do you find undervalued stocks?
Having a pool of medium to high yield dividend stocks trading at reasonable price-to-earnings ratios certainly makes investing in great businesses for the long run easier.
The article uses 2 of the metrics from The 8 Rules of Dividend Investing (dividend yield and payout ratio) together with the free stock screener Finviz to find potential bargain dividend investment candidates in 3 steps.
Step 1: The Finviz Screener
Click the "Finviz Screener" tab from Finviz's home page. This will bring you to Finviz's screener.
Step 2: Filtering by Dividend Yield
Select a minimum dividend yield to filter out non-dividend paying stocks and low yielding stocks. In this example, we are only going to look at dividend stocks yielding 3% or more.
The reason 3% was used is because dividend stocks in the 1st and 2nd highest yielding quintiles of dividend paying have historically delivered the best historical returns. Quintile 2 starts at 2.9% (which I rounded up to 3% for this example).
Dividend quintiles for the market currently are shown below (using all 3,508 dividend paying stocks in Finviz):
- Quintile 1: Dividend yield above 4.5%
- Quintile 2: Dividend yield from 2.9% to 4.5%
- Quintile 3: Dividend yield from 2.1% to 2.9%
- Quintile 4: Dividend yield from 1.3% to 2.1%
- Quintile 5: Dividend yield below 1.3%
Step 3: Filtering by Payout Ratio
Select a maximum payout ratio. In this example, we are only going to look at stocks with payout ratios below 30%. To do so, click the "Fundamental" tab, and then select a payout ratio of below 30%.
The reason 30% was used is because dividend stocks in the highest yielding third of stocks (top 33% -- we used top 40% for dividend yield above) that are also in the lowest third of dividend stocks based on payout ratio have historically produced excellent returns.
- 33% highest: Payout ratio of 63% and above
- Middle 33%: Payout ratio from 31% to 63%
- 33% Lowest: Payout ratio below 31%
How excellent have returns been?
From 1990 through June 2006 the S&P 500 generated a CAGR of 11.2%. High yield low payout ratio stocks generated a return of 19.2% - beating the market by 8 percentage points a year according to the study High Yield, Low Payout by Patel, Yao, and Barefoot.
Source: High Yield, Low Payout by Patel, Yao, and Barefoot
Moving Forward: Analysis
At this point, you will have a relatively short list of medium to high yield dividend stocks with low payout ratios.
For a stock to have a low payout ratio and a high dividend yield it must by definition also have a low price-to-earnings ratio.
You can download an Excel Spreadsheet of all 55 of the stocks that pass this screen at this link.
To find stocks in a particular sector, you can go back to the "Descriptive" tab, and filter by "Sector."
Not all stocks on this list will be great investments - in fact, most will carry higher than average risk. In aggregate, these businesses are likely undervalued.
JPMorgan Chase (NYSE:JPM) immediately stands out on the list as a business with a strong competitive advantage and a long operating history. The company did cut its dividend during the Great Recession, but another dividend cut is very unlikely in the foreseeable future.
All businesses on this list should be analyzed in detail before investing.
Caution: The Limitations of Screening
Stock screening is a useful first step in identifying businesses suitable for investment. It is certainly not the last step.
The limitation of screening is that it is purely quantitative and employs absolutely zero qualitative analysis. Further, data is never 100% accurate.
One should always confirm data on their own before investing. Stock screeners are automatic -- they are subject to data errors from source data and do not have a human filter to catch these errors.
The screen outlined in this article works well to find potential bargain dividend stocks. Determining the quality of these businesses is up to the individual investor.
Bargain businesses are not the same as high quality dividend growth stocks. The screen eliminated all Dividend Aristocrats from the list, for example. That's because quality generally comes at a premium.
A stock can be trading at a discount to fair value even if it is not on the high yield low payout ratio screen outlined above. If Coca-Cola (NYSE:KO) was trading at a price-to-earnings ratio of 14, it would most certainly be a bargain, but it still wouldn't make the screen above, as an example.
You can adjust the parameters of the screen to come up with different lists as well. Specifically, relaxing the payout ratio criteria will yield far more results that could be beneficial for long-term investors.