Hunting for the Next Dividend Winner

I'm going to give you the names of a handful of stocks, one of which could be the great dividend-paying stock in the years to come. And I'll do so with knowledge that's available to everyone, but which few people act upon.

Buy like Graham; live like the Hiltons
When it comes to investing masters, only a few names readily come to mind: Buffett, Lynch, and my personal favorite, Benjamin Graham. These are the guys whose edicts and theorems have lasted through wars, shortages, corrections, bubbles, and scandals. And through all of these times, they have made mounds of money!

In his 1934 book, Security Analysis, Graham established five principles by which investors can not only beat the market, but pummel it. Since that time, investment houses that have incorporated his philosophies have done just that. And they have done so while watching competitors flail about chasing expensive stocks in cutthroat industries.

Stock-picking firepower
So what are these little principles of magic that can nearly guarantee success in the market? Look for the following:

1. Companies with low prices in relation to asset value -- think Microsoft, with its more than $30 billion in cash and investments.
2. Companies with low prices in relation to earnings, or ones that offer generous dividend yields and low prices in relation to cash flow. Unilever (NYSE:UL) is a decent example in the food industry.
3. Companies that display a systematic and significant pattern of insider purchasing.
4. Companies that have recently experienced a significant decline in price -- First Marblehead's (NYSE:FMD) 30% slide since January, for example.
5. Companies with small market capitalizations.

Taking home the trophy
When you match all of these qualities, you'll find a stock that presents a great value in terms of price, and you'll get a company that people in the know -- e.g., the insiders -- believe will succeed. When you can find this, studies have shown that you win.

When investment house Tweedy, Browne began to incorporate some of Graham's philosophies into studies it conducted, the results spoke for themselves. For example, in their own global value fund, Tweedy bought shares of American Express (NYSE:AXP) near the beginning of 1994 only to see returns of approximately 800% since then. Time and time again, these factors together produced market-beating returns. To substantiate these findings further, it also coupled its results with 44 other studies, half of which came from foreign markets. And the same story emerged. These principles work. And they work over the boundaries of time, country, and investing environment.

The five rules are special, and they don't always exist with one another, but that doesn't mean they never do. Often, they occur simultaneously as a kind of complement to one another. For example, a company that has had a bad earnings forecast and presents a low forward price-to-earnings ratio often has also experienced a significant price decline.

Hitting the bull's-eye
For the purposes of my search, I limited the scope to companies that pay a dividend of greater than 2% and have experienced a considerable amount of buying from more than one insider (and I consider 10% owners to be in that universe). I also have foregone the fourth principle -- a large decline in price -- because I believe good entry points into great stocks are never too far off.

So here are three stocks that just might take you for a good ride:

Make it a habit
When you take an insider track that believes in the company, match it with a great dividend yield, and figure in some of the other important principles of Graham's Security Analysis, you find winners.

And these are exactly the type of companies that have bolstered the market-beating returns of the Income Investor newsletter. Take, for example, Income Investor's early sighting of Snap-on, which has returned 70% since October 2004 and still carries a 2.3% yield.

We'd love to introduce you to an even more promising group of dividend payers and Graham-friendly superstars via our Income Investor service, which you can try for free for 30 days. The picks are beating the market and recently offered an average current yield of more than 4%.

This article was originally published on Dec. 15, 2006. It has been updated.

Fool analyst Nick Kapur owns no shares of the companies mentioned above. Microsoft is an Inside Value pick. Unilever is an Income Investor pick. First Marblehead is a Hidden Gems and Inside Value recommendation. The Fool has a disclosure policy that is Graham-wellian in its effectiveness.