“Find stocks with above-average appreciation potential and safe and growing dividends, and buy them at attractive prices.”
Carlson believes investors can achieve this success by using proprietary ratings, which he makes available online for free. In this article, we discuss Carlson’s investment philosophy and then introduce his proprietary ratings to narrow down the stock universe to a more manageable collection of dividend-paying stocks.
Why Dividends Matter
When investing in stocks, we get paid in two ways—with capital gains and with dividends. Combining the two gives us a stock’s total return. While it is easy to get caught up in the daily movement of stock prices—the capital gains element of total return—it is important not to disregard the impact of dividends on this equation. In fact, according to Carlson, roughly 40% of the stock market’s long-run total return comes from dividends.
Despite the record number of companies that omitted or cut their dividends in 2008 and 2009 (Carlson points out that roughly one in eight S&P 500 companies reduced or eliminated their dividend in 2008 and about 15% did so in 2009), most firms are extremely hesitant to cut the dividend once they initiate a dividend policy. For this reason, we tend to see larger, more established and mature companies paying dividends.
For Carlson, the most important indicator of dividend safety is the payout ratio—the percentage of a company’s earnings that are paid out in dividends. If a company has $1.00 per share of earnings and pays out $0.50 per share in dividends, its payout ratio is 50% ($0.50 ÷ $1.00). All else being equal, the higher a company’s payout ratio, the more likely it is that the company will reduce or eliminate the dividend when problems arise. Carlson goes as far as to say that “the payout ratio is the single most powerful factor in analyzing the health, stability, and growth potential of a stock’s dividend.”
Don’t Be Tempted by Yield
When looking for dividend-paying stocks, many investors begin by focusing on stocks with the highest dividend yields. The dividend yield of a stock is calculated by dividing the total dividends paid out over the last year (last four quarters) by the share price. Most of the dividend yields you see quoted in the financial press or provided on financial websites are “indicated yields,” which are calculated using the stock’s indicated dividend instead of the last four quarters’ dividend. The indicated dividend is calculated by annualizing the most recent dividend: If a company’s last quarterly dividend was $0.25 per share, its indicated dividend would be $1.00 ($0.25 × four quarters). With a current share price of $20, the indicated yield would be 5% ($1.00 ÷ $20).
However, Carlson cautions against using yield as a primary screening filter. His reasoning is that yield is a proxy for risk, with unusually high yields hinting at potential problems with the firm. For Carlson, the higher the dividend yield, the greater the risk that the dividend will be omitted or cut.
Carlson points out that a stock’s yield will rise because of two events: 1) the dividend increases and/or 2) the stock price falls. He views yield as a proxy for risk because more often than not, very high dividend yields are caused by falling stock prices, not by rising dividends. A rapidly declining stock price is a very good indicator that there is something wrong with a company.
In order to determine if a stock’s yield is potentially too high, Carlson suggests comparing it to the company’s sector or industry yield; to the yield of the overall market, as represented by an index such as the S&P 500; or to the stock’s long-term average yield. When the yield is considerably higher than these benchmarks, Carlson feels this to be a red flag of potential problems.
Seeking Dividend-Paying Stocks
When seeking out dividend-paying stocks, Carlson stresses the importance of evaluating dividends and yields differently. He suggests that dividend investors consider the following:
- Safety and dependability of the dividend: Bigger isn’t always better when it comes to dividend yield. As we have stated, Carlson views dividend yield as a proxy for risk. A yield is useless if the company can’t support the dividend payment going forward. Carlson wants a “big” dividend that is going to be around today, tomorrow and well into the future.
- Capital gains potential of the stock: Carlson isn’t merely an income investor. He is a total return investor. Therefore, he does not ignore the capital gains prospects of a stock. As he puts it, a “big” yield is meaningless in the face of significant price losses.
- Yields on alternatives: When considering dividend yields, Carlson cautions against getting wrapped up in absolutes. Instead, he suggests comparing the yield of a stock to those of other investments. Even if, in absolute terms, the yield seems low, the stock’s yield may be favorable compared to the alternatives.
- Yields on comparable investments: It is also a good idea to compare dividend yields across industry/sector and market benchmarks. When you find a yield that is significantly higher than that of its industry or the overall market, there is a strong likelihood that this dividend is about to go away.
- Pretax versus after-tax yields: Carlson reminds the reader that it is important to consider both the pretax and aftertax yields, especially if you are holding investments outside of a retirement account.
- Dividend growth potential: Lastly, Carlson stresses the importance of seeking out dividend-paying stocks generating the best total returns over time. As a result, you need to consider the dividend growth potential of a stock. However, he warns against using your own personal income needs in selecting dividend-paying stocks. Just because you “need” a 6% yield doesn’t mean that you should be seeking out stocks yielding 6%. Instead, he advocates picking dividend-paying stocks on their merits. This is why he doesn’t use dividend yield as a primary filter for dividend-paying stocks. Instead, he filters stocks based on proprietary ratings that attempt to gauge the total return potential of a stock and uses yield only as a secondary filter.
In his book, Carlson introduces his big, safe dividendformula for picking attractive dividend-paying stocks. Actually, he discusses two BSD formulas: basic and advanced. However, for this article we focus on the basic BSD approach.
Basic BSD Formula
Carlson’s basic BSD formula is based on two premises:
- A company cannot pay dividends if it doesn’t have the money to do so; and
- You should choose stocks based on their total return potential, not just dividend return .
His basic BSD formula uses two data points to address these issues:
- Payout ratio; and
- Overall Quadrix score.
As we mentioned earlier, a stock’s payout ratio measures how much of a company’s profits (earnings) are paid out as dividends. For Carlson, the payout ratio is an indicator as to whether a company can maintain and grow its dividend. The smaller the percentage of earnings a company pays out in dividends, the more of a “cushion” it has to grow the dividend, or at least maintain it should earnings decline.
For Carlson, a “safe” payout ratio is anything below 60%. While he admits that using an absolute cutoff will eliminate stocks in industries with historically high payout ratios, he feels better knowing he is also eliminating stocks with potentially higher risk (as indicated by the higher dividend yield).
The second element of Carlson’s basic BSD formula is the Quadrix Score—a proprietary stock-rating system developed by Dow Theory Forecasts (now called Horizon Publishing), the investment newsletter publisher where Carlson works. Carlson uses this multivariate system to identify stocks demonstrating balanced and broad growth. The Quadrix system ranks over 4,000 stocks based on more than 100 variables across six categories:
- Momentum (growth in earnings, cash flow and sales),
- Quality (return on investment, return on equity and return on assets),
- Value (price-to-sales, price-earnings and price-to-book ratios),
- Financial strength (debt levels),
- Earnings estimates, and
- Performance (relative stock price performance).
According to Carlson, some variables are weighted more heavily based on their past effectiveness. The overall Quadrix score is a weighted average of the six category scores. However, the Quadrix stock-rating system is a “black box,” or proprietary, system, so Carlson does not go into too many specifics as to how the score is calculated or the weightings assigned to the different variables. The Dow Theory Forecasts website does offer some details as to how the Quadrix Score is calculated (www.dowtheory.com/quadrix_explained.asp) but is still not explicit about its construction.
The overall Quadrix score is a percentile ranking, so a reading of 90 means that a stock scores better than 90% of the stocks in the Quadrix universe. Carlson focuses on stocks that rate in the upper quartile (those with an overall Quadrix score of 75 or higher out of a possible 100).
To help investors, Carlson’s website (www.bigsafedividends.com) provides the payout ratios and overall Quadrix scores for all the dividend-paying stocks in the S&P 1500 composite. Access to the site is free, but you are required to register using an email address.
Basic BSD Formula Filters
Carlson goes on to describe a simple stock-filtering system based on his basic BSD formula:
Filter 1: Focus on stocks with payout ratios of 60% or less.
Filter 2: Focus on stocks with overall Quadrix scores of 75 and higher.
Since the Quadrix scoring system is proprietary, we used Carlson’s free website to do the filtering for us. We found payout ratio and overall Quadrix scores for the 1,009 stocks in the S&P 1500 that pay a dividend as of May 17, 2017.
Exporting this data to an Excel spreadsheet, we first ranked the companies by their Quadrix score and kept the 290 companies whose Quadrix score is 75 or higher.
We then ranked the remaining companies by payout ratio and eliminated 34 additional companies that either did not have a payout ratio, had one that was higher than 60% or had a payout ratio that was negative.
While we narrowed down the initial universe of 1,009 companies to 256, this is still a rather unwieldy collection of stocks. As our final sorting criterion, we looked to the dividend yield. Previously, we mentioned that Carlson discourages investors from using dividend yield as a primary filter when looking for dividend-paying stocks. But since we used the payout ratio to isolate stocks that Carlson judges have a safe dividend that is likely to grow as well as those with the potential for “balanced and broad strength,” as indicated by the overall Quadrix score, we can now use yield as a secondary filter by highlighting those remaining stocks with the highest dividend yields.
Overview of Passing Companies
Carlson’s simple BSD formula screen requires stocks to have payout ratios no higher than 60%. The median payout ratio for the 256 passing the simple BSD filters was 27% as of May 23, 2017.
In order to receive a high value score, the Quadrix system looks at such ratios as the price-earnings, price-to-sales, price-to-cash-flow, and price-to-book ratios; dividend yield; and price-earnings ratio relative to expected earnings growth (forward PEG). These ratios are compared to the average level of the ratios over the last three and five years, and stocks that are most attractively valued relative to these historical levels receive the highest value score.
The median price-earnings ratio for the 256 companies passing Carlson’s simple BSD formula screen as of May 17, 2017, is 17.6. This is lower than the price-earnings ratio of the typical exchange-listed stock, which is 21.4. The price-to-book ratio of these companies is 2.5, which is higher than the 2.0 for exchange-listed stocks. Furthermore, as we mentioned earlier, most stocks do not pay a dividend. Therefore, the median dividend yield for exchange-listed stocks is 0%, while the median for these simple BSD formula stocks is 1.7%.
To score high in terms of quality in the Quadrix system, a company must demonstrate strong growth in sales, earnings, cash flow, common equity, and dividends over the last one, three and five years. The stocks passing the simple BSD formula screen as of May 18, 2011, have a median five-year historical earnings growth rate of 13.2%, which dwarfs the median growth rate of 5.3% for exchange-listed stocks. Our starting universe was the 1,009 dividend-paying constituents of the S&P 1500, which tend to be more mature, slower-growing firms. However, we do not see that much of a disparity in the projected earnings growth rate for the next three to five years between the 256 companies passing the BSD simple screen and the typical exchange-listed stock (10.4% versus 10.9%). The five-year dividend growth rate for the simple BSD formula stocks is 14.1%.
Looking at performance, the Quadrix system places a premium on strong short-term performance from two to 12 months. The stocks currently passing Carlson’s simple BSD formula screen have outperformed the S&P 500 index by nearly 9% over the last 52 weeks, while the typical exchange-listed stock has underperformed the index by a little more than 1% over the same time period.
It is impossible for us to independently test the performance of Carlson’s simple BSD formula. According to his book, a portfolio of stocks meeting these criteria, rebalanced at the beginning of each year, would have outperformed the S&P 1500 index by an average of four percentage points a year from the end of 1994 through 2009, and with lower risk than that of the index.
Charles Carlson is a total return investor looking for stocks providing income in the form of safe dividends that he expects to grow over time, as well as a strong financial foundation to generate price gains. He uses his company’s Quadrix stock-rating system to filter the dividend-paying stock universe to find such candidates.
Quantitative systems such as Carlson’s are excellent ways for investors to hone in on attractive investment candidates that warrant additional analysis. However, quantitative stock selection systems are only one piece of the selection process. A qualitative element is equally important. For this reason, investors must still perform their own due diligence to make sure the investments they select meet their own time horizon and risk tolerances.
This is an updated version of the article that originally appeared in the Third Quarter 2011 issue of Computerized Investing. That article is available online here: http://www.aaii.com/computerizedinvesting/article/screening-with-the-big-safe-dividend-formula.