Last week, I interviewed author Hewitt Heiserman, Jr. to ask him how he might screen for the types of conservative growth stocks he outlines in his terrific book, It's Earnings That Count. We considered a number of factors in searching for potential market beaters. Here's a short recap:
- Annual earnings per share growth of 7% or better over at least the last 12 months.
- Average five-year revenue growth of 8% or better.
- Average five-year return on equity (ROE) of 10% or better.
- Debt equaling no more than half of equity.
- Institutional ownership of 60% or less.
- A short interest ratio of 5% or less.
- A price-to-earnings ratio lower than the industry average.
You can read last week's commentary if you're really interested in why these criteria are so important. Or, if you're a subscriber to Motley Fool Hidden Gems, you can get access to the private discussion boards, where Mr. Heiserman posted a checklist of the ideal attributes of a conservative growth stock. To summarize, though, the idea is to find firms that are growing, but not peaking, and which feature good capital and balance sheet management. And, of course, it doesn't hurt if the Street isn't paying much attention to our prospects.
Interestingly, last week's screen yielded more than 40 stocks. That's far too many, so we narrowed the list by applying a price-to-earnings-to-growth, or PEG, ratio of less than 1.5. That brought our list of candidates down to nine, from which we ultimately chose three of the best.
Forget growth, gimme cash
I'm pleased with the choices, of course. But after further consideration this week I wondered whether we were really addressing all the conservative Foolish investors out there with this approach. I mean, really, some Fools simply don't want to wait. Some want cash money -- you know, dividends -- from their investments now with the possibility of greater returns long-term. (This is, after all, the founding principle of our Motley Fool Income Investor newsletter.)
So, as investors are wont to do, I decided to tinker with the screen to seek potentially undervalued dividend-paying winners. Here's how:
- Replace debt-to-equity with an interest coverage ratio of at least two.
- Replace short interest with a dividend yield of at least 3.1%.
- Add a dividend growth rate of at least 5% over the past five years.
- Add a price/book value ratio of no more than three.
Why the additions and subtractions? Many very good dividend-paying stocks strategically use leverage to earn higher profits. But we want to eliminate companies that can't pay their obligations -- hence, the interest coverage requirement. Interest coverage divides the last 12 months' earnings before interest and taxes by interest payments over the same period. So, for example, a firm with an interest coverage ratio of two generates double its interest payments in raw income.
Short interest is also less of an issue here because we're no longer talking about growth stocks. For dividend-paying winners, price dips can be very, very good, so long as dividends are being reinvested. Plus, short sellers in high-dividend-paying stocks foot the bill for the payouts.
Since we're seeking cash, we may as well set our sights high, so I included a minimum dividend yield of 3.1%, which doubles the rate of the S&P 500 as of this writing. (For more on why it's good to have a market-beating dividend, click here.)
A record of dividend growth is important, too, for some of these companies may see their shares remain essentially flat for years. A steadily increasing payout, constantly reinvested, could more than compensate for this apparent problem and may even deliver market-crushing returns on its own.
Finally, the price-to-book ratio measures the price of a company's stock compared to the value of its tangible assets. Legendary investor Benjamin Graham sought to buy companies under their book value as often as possible, figuring that he'd do well in stocks priced for less than their total net worth. He was right. Though few such bargains exist today, it's worth being cautious around any stock that trades for well above its book value. Such companies are priced for promises they may never deliver. Finding dividend-paying winners priced near their book value provides at least some assurance that we aren't seeking high yields from stocks whose share prices are being propped up by little more than hope.
Four stocks that give like Santa
So, what did my stock screener at MSN Money come up with? How about four stocks that give like Santa. Have a look:
Each of these candidates is attractive for its mouthwatering, market-trouncing yields. But not all of them are fit for a Fool's portfolio. For example, problems abound at New York Community Bank
Last, but certainly not least, is Income Investor pick AnnalyMortgage Management
Foolish holiday wishes
Dividends are like gift cards. You get cold, hard moolah and then put it to work any way you want. Some investors love this idea. Others only care to see their stocks go up, up, up. Whatever approach you take as an investor -- growth, value, income, Rule Breaker, or dartboard -- it's worth noting that screens such as this and last week's are no substitute for Foolish fundamental analysis. Doing the work isn't hard, can be intellectually rewarding, and may allow you to achieve your dreams and the dreams of those around you. Now how's that for a Christmas present? Happy Holidays.
Like most of us, Fool contributor Tim Beyers isn't a Harvard-trained financial analyst but rather a common Fool who learned to invest by building a portfolio, one stock at a time. Tim doesn't own shares in any of the companies mentioned in this story. You can view Tim's Fool profile and stock holdings here . The Motley Fool is investors writing for investors .