In troubled times, dividends are king

The financial press is full of doom – it seems at least once a week the headlines include ‘Market loses billions’, and Greece seems like the world’s slowest train wreck in motion.

In such a negative environment, it’s hard to ignore the headlines and the experts – and even harder not to take it personally when your portfolio falls by a couple of percentage points at least once a week, most weeks.

Opportunities abound
The Motley Fool has been pretty clear that now is not the time to run. In fact, we’ve been finding plenty of opportunities. Many of those opportunities are in companies for whom the market has ascribed bleak futures. Sure, some opportunities are in companies whose profits have taken a short term hit, but some don’t even need an uptick in profits – just the removal of the fear discount that has been applied at the moment.

Even then, for some investors the waters are still too murky to take the chance of jumping in. Waiting for an eventual increase in profits or earnings multiples is just too much uncertainty for some. I think those people are probably missing out on some great opportunities, but who can blame them?

Show me the money
If that’s you, or if you just prefer a little more certainty for your money, I have a solution that may help – dividends.

There’s no guarantee that any company will always pay dividends, but choosing well should give you a regular income stream while you wait for your investment to bear fruit. If the price doesn’t move any time soon, you’re being paid to wait. If it does, then you get the best of both worlds – income and capital growth.

Just paying a dividend isn’t enough to qualify a company for inclusion on this watchlist. There are additional criteria we can apply to tilt the odds further in our favour. Here’s a four-step plan to do just that.

1. Dividends paid from Profits
In the first instance, you want that dividend to be sustainable. Like a consumer living on credit, there’s only so long a company can pay dividends that are in excess of its earnings. Accordingly, I chose to filter out companies that paid out more than 85% of their earned profits in dividends.

2. A good yield
Not wanting to pay too much for those dividends is important – and if you’re looking for an income stream, you need a reasonable yearly return on your money. Accordingly, let’s set a floor of 4% for our trailing dividend yield, to improve our income, and to ensure we’re not paying too much.

3. Growth
Another filter worth applying is dividend growth. Sure, it’s nice to know we’re being well rewarded this year, but we also want dividends that will grow over time. Inflation will take a bite out of our earnings, so we want to do better than that, and who doesn’t want to have more to spend next year than last year? Dividend growth of more than 10% is a good start.

4. Business and management quality
Lastly, we only want great quality businesses. One analytical tool we can employ is Return on Equity. This measure tells us how good management are at turning shareholders’ money into profits. To cull the list to only the best candidates (on this measure), I’ve picked a hurdle rate of 20%.

Out of the 2,000 plus companies on the ASX, this process has whittled down the field to a manageable number. Included in that list are, large, quality companies of the calibre of Coca-Cola Amatil (ASX: CCL), Flight Centre (ASX: FLT), Iress (ASX: IRE). In addition, smaller names such as Thorn Group (ASX: TGA) and 1300 Smiles (ASX: ONT) also feature.

Foolish take-away
There is nothing magical or sacred about the thresholds I chose, and investing solely by the numbers can be a dangerous game. You should always use screens like these as a starting point for deeper analysis, not ends in themselves, but they can be particularly helpful in unearthing smaller companies that may otherwise not grab your attention.

Equally, these screens can filter out companies that are otherwise quality investment candidates – one size never fits all, so make sure you use different approaches.

You can’t beat cold, hard cash – especially in times of uncertainty. A combination of healthy, growing dividends, high returns on equity and a reasonable price (in this case using dividend yield as a guide) is one way to participate in the market’s upside while being paid to wait for it to eventuate.

If you are looking a stock paying an above average dividend, readers need look no further than The Motley Fool’s Top Stock For 2012. Click here now to request this special report, while it’s still free and available

Scott Phillips is The Motley Fool’s feature columnist. Scott owns shares in Coca-Cola Amatil. The Motley Fool has a disclosure policy. This article authorised by Bruce Jackson.

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