Morningstar Advisor - Summer 2007 - (Page 60)

Screens So You Say You Want Income? by Jeffrey Ptak If it’s market-beating dividend yields you’re seeking, you won’t have to squint all that hard to find them. Of the roughly 7,800 common stocks that we track in Morningstar Advisor Workstation, nearly 1,500 were yielding at least as much as the S&P 500 Index as of May 31, 2007. With plenty of aboveaverage yields to go-around, it seems that the key to successful dividend investing isn’t quantity, but quality. But how does an investor identify “quality” high-yielding stocks in any kind of systematic way? While there’s no surefire method, a few hallmarks are worth bearing in mind: Avoid shrinking dividend payouts Seek financially stable firms that throw off plenty of profit and cash flow Favor those with intractable competitive advantages Aim to invest at a reasonable price narrow our gaze to stocks where the dividend payout per share has been increasing over time. While our choice of growth rate is inherently arbitrary, we’ll use 10%, as this connotes a reasonably strong level of underlying business growth. Though a growing dividend stream and a strong balance sheet might seem to afford ample protection, we prefer an extra bit of insurance—copious profits and cash flow. In surfacing companies that generate profits well in excess of what’s needed to fund the dividend, we can rest better assured that there will be adequate resources on hand even when the going gets tougher. To that end, let’s insist that our companies’ boast payout ratios at or below 50%. (A company’s payout ratio is the ratio of dividends paid to profits; the lower the ratio, the more flexibility a company retains in maintaining or growing the payout.) and Payout Ration TTM 50% Dividend Yield % Current and Dividend Growth % 5 Yr 1.75 10 For our screen, let’s first weed out stocks where the dividend payment has been in gradual retreat. We think it’s worthwhile to avoid these stocks because that trend could portend future reductions that cut into our income stream. Thus, we should But dividend growth isn’t necessarily enough. For example, a company could be levering up its balance sheet in order to finance dividend payouts, essentially mortgaging its future to maintain or grow its dividend-income stream. To ward against that possibility, let’s further narrow our search to avoid companies that are especially debt-laden. Though heavy leverage is often in the eye of the beholder (especially with banks where leverage is an integral part of the business model), let’s take a conservative tack and exclude companies whose financial leverage exceeds 2.0. (Financial leverage is the ratio of a firm’s assets to its stockholders’ equity; therefore, the more debt on the balance sheet, the higher the financial leverage ratio.) and Finc Leverage Latest Qtr 2.0 Further, by limiting our scope to companies that generate impressive free cash flow margins, we can rest better assured that those profits aren’t just a figment of some crafty accountant’s imagination. (A firm’s free cash flow margins is equivalent to its free cash flow divided by sales; free cash flow is operating cash flow less capital expenditures.) and Free Cash Flow/Sales % – Trailing 12 Month 20 While it’s great to surface the high-yielding stocks of companies that are growing, financially secure, and robustly profitable, it’s also worthwhile to consider whether the good times will last. For example, some highly cyclical companies could match this profile to a “t” if we happened to examine their growth and finances just as the good times were cresting in their respective industries. Once the good times faded, however, the picture could change markedly, throwing our original thesis into question. To mitigate that risk, let’s further narrow our search to companies that, in the view of Morningstar’s stock analysts, boast 60 Morningstar Advisor Summer 2007

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Summer 2007

Morningstar Advisor - Summer 2007 Contents Letter from the Publisher Get to Know the Bond “All-Stars” Research Briefs Our Stewardship Test Gets Tougher Save It for Later Too Many Oranges Best of Both Worlds No Two Clients Are Alike When It Comes to VAs, It’s Seller Beware Hands On: Finding the Suitable Fund Share Class for Your Client Fund Style Can Drift Off Course Sticking to Their Style, Through Thick and Thin Marathon Man Growth, With a Chaser A Menu of Ideas to Fill Five Market Baskets Funds: Finding Funds with Conviction Stocks: So You Say You Want Income? All Eyes on China Mutual Fund Analyst Picks Undervalued Stocks Most Popular Variable Annuities What’s New at Morningstar and on the Web The Advisor’s Economic Moat

Morningstar Advisor - Summer 2007

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