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Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.
Value investing and dividend investing are cousins. They don't always agree but they usually have something interesting to say to one another.
Value investors want to find stocks that look cheap on various measures of financial merit, while dividend investors like stocks trading at low prices compared to the dividends they pay.
Combining a search for dividends with a nose for value often produces good results. But let's take a look at a few practical issues you might encounter when looking for stocks with this tempting combination of features.
I'll start with a simple screen I ran to identify prospective bargains on the TSX. On the dividend side of the equation I looked for yields north of 3 per cent. On the value side, I sought stocks with positive price-to-earnings ratios (P/E) less than 10.
A recent jaunt to Globeinvestor.com's basic stock filter produced a list of 53 stocks that met both requirements. The full list, sorted by market capitalization, is shown in the accompanying table.
This simple screen highlights several interesting stocks – some of which I own – that are worthy of investigation. But the point here is that stock screens are just the starting point. It is important to be aware of many issues, big and small, when using them.
One issue is the difficulty you may find in buying or selling smaller and relatively illiquid stocks. If trading volumes are too low, the gap between bid and ask prices can be large. You may find yourself unable to buy a stock you want at a reasonable price or locked into a stock you no longer want to own.
For this reason, smaller and infrequently traded stocks should generally be avoided by novice investors. However, they can be quite interesting to old hands with modest portfolios who are willing to be patient when getting in and out of them.
Another stumbling point can arise when dealing with companies that have multiple share classes. Usually one share class has limited voting rights and trades more frequently than the other class, which often gets more votes. It is important to look up the details of each class when dealing with such stocks.
Other red flags can also pop up, often signalled by extreme numbers of one sort or another.
For instance, dividend investors know that stocks with supercharged dividend yields deserve extra scrutiny. A very high yield may be a sign of distress. In demanding a big payout now, the market is implicitly indicating some doubts that the dividend is sustainable.
The humble price-to-earnings ratio (P/E) can also hide peculiarities because it's often not clear which number is being used for earnings. Trailing earnings over the last four quarters? Estimated earnings over the next four quarters? To complicate things even more, trailing earnings can be reported in various ways. Sometimes they represent earnings before extraordinary items; other times they include all items.
Just as with very high yield stocks, particularly low P/E ratios are often misleading in some way. It is wise to investigate them further.
Consider Indigo Books & Music. The Toronto-based firm runs Canada's largest chain of book stores and competes in the online space with Amazon.com. Indigo's business is under pressure from e-books. As a result, it's trying to move beyond just selling books and into complementary areas.
Indigo recently achieved success in the new e-reader market with its Kobo venture, which it sold off for $146-million (U.S.) to a Japanese firm earlier this year. The sale goes a long way in explaining why Indigo's P/E seems incredibly cheap – just a hair above 2. Without the proceeds from the deal, the company would have lost money over the last four quarters.
Mind you, this deficiency might not preclude an investment based on Indigo's other features. For instance, it trades at a low price-to-book-value ratio, has a large cash hoard, and it will likely be modestly profitable over the next year. It might be a good buy – just not on the basis of its P/E.
Indigo illustrates why it's a good idea to poke and prod a company's earnings to see what's going on. In some cases low-P/E stocks have temporarily inflated earnings. In others, a calamity may have occurred which will depress earnings. Either way, it is important to determine what's actually going on and not to blindly rely on a few narrow data points that you've screened for.
Despite such issues, I think the simple low-P/E plus high-yield screen is a pretty good place to start when looking for potential bargains.
Sure, they aren't all gems, but you only need to spot a few good stocks to make it worthwhile.
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Norman Rothery