The Safest Dow Dividend Stocks

Posted by Dan Hung

January 26, 2009

After reading a bit on the Dogs of the Dow theory and doing a little research of my own on large cap returns, I seem to have convinced myself of the opportunity that may lie within U.S. large caps at the moment. Never in the last ten years do I think we’ve had the opportunity to buy the security of U.S. large caps with an opportunity for both capital appreciation and equity income returns. Obviously, part of the reason is that U.S. large caps are not quite as “secure” as we thought they were. But, if we know how to look, it’s possible to find financial secure firms that will hopefully weather the storm and provide some very nice returns.

Dow Dividends

To demonstrate my process for ascertaining the security of a dividend, I’ve run a quick dividend screen on the Dow using information available through the Yahoo! Finance Stock Screener. (Given that many of these companies are issuing 4th quarter press releases, I’ve done my best to update EPS and FCF. Because audited balance sheets are typically not available in the releases, Debt/Equity and Current ratio numbers are likely from last quarter.) The screen looks for stocks with dividend yields > 3%, FCF Payout Ratio % < 60%, and Current Ratio > 1.

The dividend yield criteria is obvious. We’re looking for companies which offer attractive income return. It’s anyone’s guess when the stock market will rebound, but a secure dividend will provide the necessary cushion to ease the blow of interim volatility.

You may be wondering why I look at free cash flow payout ratio as opposed to the traditional payout ratio which uses net income. This is because dividends are ultimately paid out of cash flow not GAAP net income. In the long run, net income is a more appropriate denominator because it provides a look at the run rate cash distribution/investment choices being made by management. But, in a recession, we care about the security of the dividend regardless of earnings. In fact, an argument could be made that in an environment which presents very few viable investment opportunities, paying out cash in excess of net income (or simply hoarding it) is the most responsible decision management could make.

Finally, we look at current ratio which is a liquidity ratio. The goal here is to identify companies which should comfortably be able to service it’s liabilities over the next year. I choose current ratio > 1 in the screen, but generally we look for current ratio ~2 to be a healthy level. An even more conservative approach would be to look for quick ratio > 1. Given the global credit crisis, you can see why this would be a concern for us. In addition to examining a target’s ability to service current liabilities, I’ve also loaded debt-to-equity ratios into the screen. A lazy investor would simply keep a very strict and very low tolerance for debt-to-equity (i.e. <1). But, one who’s more savvy and apt to take on higher risk for return ought to continue his diligence to determine just what the debt is composed of. Maturity dates (timing risk), lenders (counter party risk), and interest rate (interest risk) are all important factors in determining “good debt” from bad. For example, a 5:1 debt to equity ratio might not be that bad for a Company which has secured long term financing and will likely be able to refinance years from now despite the fact that the market is punishing its stock due to current credit market worries.

On a final note, you’ll notice that Verizon Communications doesn’t quite fit the criteria of my screen. In addition to wanting to submit ten stocks for your perusal, I added this because I wanted to show a Company who’s stock has held up generally well, but has a low current ratio. This doesn’t mean the Company is insolvent. In fact, it’s likely just more a nature of the Verizon business – a mature telecommunications services provider. You’ll notice that despite relatively modest shareprice depreciation, the stock provides 6% dividend and pays out nearly all of its net income. Management of a mature business ought to do this. Generally low debt-to-equity also leads me to believe that the Company is likely in the process of reducing debt load as its need to lever for growth diminishes.

Obviously, this list is just an initial screen. There are definitely some interesting picks in there and all are trading well below their 200-day moving averages implying (if you believe in it) potential for mean reversion in addition to very attractive dividend yields. I’d be interested to hear thoughts from anyone who’s looked at these stocks in more detail as far as whether or not they feel my screening criteria were at least directionally correct.

Full Disclosure: Long shares of GE at the time of writing. No positions in any other stock mentioned.