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Paying Dividends

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Last week the stock market had a good week, and the bond market corrected a bit. Still, relative to the yield on the 10-year t-note of 2.71% on Friday, stocks look extremely attractive.

The S&P 500 is trading for just 13.4x consensus expectations for 2010, and 11.6x 2011 expectations. That translates into earnings yields of 7.46% and 8.62%, respectively. However, an earnings yield does not provide you with that much cash in your hand.

For an apples to apples comparison, it is the dividend yield that is worth looking at. Of course, that which is not paid out in the form of dividends is held on your behalf to be reinvested in the business, or is returned to you by the company buying back stock. From a tax efficiency standpoint, stock buybacks are a better way to return cash to shareholders than are dividends, but they do not provide the same satisfaction as a check in the mail every three months (or more likely a credit to your brokerage account).

The Income-Oriented Screen

I decided to look for stocks that are an attractive alternative to t-notes for income-oriented investors. To do so I first looked for those firms that are currently yielding more than 2.71%, the t-note yield on Friday. Then I wanted to make sure that the dividend is sustainable. To do that, I weeded out all the companies that were currently paying out more than 75% of their earnings.
I also wanted companies that have been growing their dividends. If a company has a history of raising its payouts, it is more likely to do so in the future than those that go for long periods of time with stagnant payouts.

This screen was not all that rigorous; I only looked for 2% annual dividend growth over the last five years. Mostly that ensured that these were not companies with a recent history of cutting their dividends. I also wanted companies that were investable for most people, so I required a market capitalization of over $500 million.

While dividend investing is usually best suited for long-term investors, not short-term traders, I wanted to make sure that these were timely additions to ones portfolio. For that I used the Zacks rank, and required that it be either a #1 or a #2. The Zacks rank is driven by earnings estimate revisions and earnings surprises. It has an excellent history of predicting short-term price movement.

This final screen means that these stocks are in the top 20% of all stocks based on these near-term fundamentals. These are stocks that have been reporting better-than-expected earnings, and for which the analysts who follow them most closely have been raising their expectations for this year and next. While the Zacks rank can be volatile -- and thus is not the best tool to make investment decisions that are going to be held for four or five years -- you might as well get some near-term performance out of your portfolio if you can. It also made for a more manageable list -- without it, the screen would have had 196 names on it.

From this screen it is possible to develop a well-diversified portfolio. This is not simply a list of electric utilities. There are many different economic sectors represented. The Financial sector is heavily represented, but there are also energy companies, industrials, basic materials and several Tech firms as well. Several of the 29 firms that make the final cut are located overseas. That adds further diversification.

Ten Years is a Long Time to Be Making Just 2.7%

One thing is certain, if you buy a ten-year t-note, your coupon will never go up. You will get your 2.71% and then your principal back at maturity.

While inflation does not look like a major problem today, the world can change a lot in ten years. After all, ten years ago today, we were still living in a pre-9/11 world. It would not take that much inflation in, say, 2015 or 2016 to take a big chunk out of your real return for the ten years you have your money locked up. You could sell the bond early, but if inflation is showing up, then interest rates will be rising and you will take a capital loss on your bond.

In moderate inflation environments, companies have the flexibility to raise prices and earnings, and thus increase the dividend to give you some inflation protection. This is a more conservative way to invest based on the historically low t-note yields than using a short bond ETF like the ProShares UltraShort 20+ Year ETF (TBT - Free Report) .

Over the next ten years, it is far more likely that most of these firms will raise their dividends than cut them. If you buy them now, you are already doing better than you are in the 10-year note, and for 10 of the stocks even better than the 30-year yield.

Historically it has been very hard to find stocks that have dividends higher than the 10-year treasury note, at least over the last 50 years or so. That is not true today. Thus, this might be a historic opportunity to buy some very high-quality dividend-paying firms.

Of course, any screen should just be a staring point for further investigation. But starting your investigation with the bird in the hand of a high dividend yield probably means you are looking in the right place.

Company Ticker Div. Yield Payout Ratio Div. 5-Yr Growth P/E Using Current FY Est. P/E Using Next FY Est. Zacks Rank
Royal Dtch Sh-B RDS.B 6.15% 0.72 9.48% 8.51 6.44 2
Alliance Res ARLP 5.93% 0.68 15.27% 8.1 7.94 1
Telefonica S.A. TEF 5.44% 0.5 44.75% 10.56 11.06 1
Portugal Telcom PT 4.76% 0.52 10.52% 16.08 13.33 2
Safety Ins Grp SAFT 4.74% 0.44 22.01% 12.17 11.85 2
Commnty Bk Sys CBU 4.17% 0.57 4.33% 12.69 12.08 1
Shaw Comms-Cl B SJR 4.09% 0.66 42.97% 14.78 14.02 2
Banco Macro-Adr BMA 4.05% 0.39 35.32% 10.77 10 2
Taiwan Semi-Adr TSM 3.82% 0.45 11.11% 11.1 11.39 2
Banco De Chile BCH 3.79% 0.66 14.19% 15 13.66 2
Providnt Fin Sv PFS 3.64% 0.63 5.17% 13.67 11.67 1
Erie Indemnity ERIE 3.56% 0.71 8.59% 17.59 18.31 2
Northwest Nat G NWN 3.55% 0.59 4.91% 17.15 16.5 2
Textainer Group TGH 3.54% 0.52 5.26% 11.61 10.41 1
Northeast Util NU 3.48% 0.59 8.95% 14.78 13.35 2
Sonoco Products SON 3.39% 0.52 4.26% 14.06 12.62 2
Kla-Tencor Corp KLAC 3.29% 0.39 6.65% 7.67 7.6 2
Ppg Inds Inc PPG 3.14% 0.52 3.35% 15.02 13.49 1
Hubbell Inc -B HUB.B 3.03% 0.42 2.08% 13.75 11.92 1
Linear Tec Corp LLTC 2.99% 0.57 16.52% 12.47 11.82 2
Analog Devices ADI 2.97% 0.44 16.60% 12.72 11.51 2
Cato Corp A CATO 2.96% 0.41 5.66% 13.36 12.52 2
Basf Ag-Adr New BASFY 2.89% 0.36 23.25% 9.59 9.32 1
Greif Bros-Cl A GEF 2.86% 0.38 34.15% 13.76 11.55 2
Wd 40 Co WDFC 2.78% 0.45 3.28% 15.72 14.41 2
Utd Fire&Caslty UFCS 2.75% 0.71 5.96% 12.33 27.29 2
Astrazeneca Plc AZN 2.73% 0.38 16.69% 7.8 7.88 2

Dirk van Dijk, CFA is the Chief Equity Strategist for With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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