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What are we looking for?

Stocks with low payout ratios that could raise their dividends.

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Dividend stocks have done well over the past year. However, a high dividend yield may indicate above-average risk. To find stocks with strong potential for total return, you have to examine fundamentals.

An interesting methodology for doing so is described in Charles Carlson's book, The Little Book of Big Dividends. Mr. Carlson believes that the dividend payout ratio – the annual dividend divided by the trailing 12-month earnings per share – is a powerful tool for spotting companies that can maintain and grow their dividends. The payout ratio makes up almost a third of the total weight in his Advanced BSD (Big, Safe Dividends) Formula.

The payout ratio is important because earnings go up and down. A modest payout ratio gives the company the ability to maintain its dividend even if earnings hit a bump.

Mr. Carlson doesn't rely solely upon the dividend payout ratio. He also uses what he calls the Quadrix ranking system, which measures momentum, value, quality, financial strength, earnings estimate revision, stock price change and trading volume metrics.

He back-tested his approach to 1994, assuming a hypothetical investor would have bought all of the S&P 1500 stocks that were in the top 20 per cent of the BSD screen and that were in the top 25 per cent of his Quadrix ranking system, and repeated the process annually. His test portfolio outperformed the S&P 1500 Index by more than 6 per cent per year.

Using the CPMS database, I ran Canadian stock back tests going back to November, 2002, with my version of the Advanced BSD Formula using a portfolio with a maximum of 25 stocks. The historical volatility of the Canadian income portfolio was higher than the S&P/TSX composite index, but the strategy outperformed by about 4 per cent per year.

What we learned

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The payout ratio is an important factor in measuring dividend stability and potential for dividend increases. However, there's a caveat: Actual cash flow may fall short of analysts' estimates, causing the stock price to decline and expected dividends to be cut.

Robert McWhirter, CFA, is president of Selective Asset Management Inc.

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