Screening With the Big, Safe Dividend Formula: The Advanced BSD Approach

In the Third Quarter 2011 issue of Computerized Investing, we introduced Charles Carlson’s big, safe dividend (BSD) formula (you can access this article here). This approach is intended to “find stocks with above-average appreciation and safe and growing dividends.” In “The Little Book of Big Dividends: A Safe Formula for Guaranteed Returns” (John Wiley & Sons, 2010), Carlson discusses two big, safe dividends formulas; our article in the last issue covered the basic approach, which relies solely on the payout ratio and Horizon Publishing’s proprietary Quadrix Score. Using Carlson’s free website (www.bigsafedividends.com), users can sort the stocks of the S&P 1500 to find promising candidates based on the basic BSD formula.

Carlson’s second formula is the advanced BSD screen, which combines 10 different factors with different weightings into a composite score. In this article, we outline the advanced BSD approach and attempt to create our own composite score and apply it to the universe of stocks using AAII’s fundamental stock screening and research program, Stock Investor Pro.

Advanced BSD Formula

Carlson’s advanced BSD formula uses 10 fundamental and price momentum factors and assigns different weightings to each of them in order to arrive at his composite score. These factors and their weighting are as follows.

Payout Ratio

As in the basic BSD formula, the payout ratio plays an important role in the advanced BSD formula. The payout ratio is a measure of how much of a company’s profits (earnings) is paid out as dividends. For Carlson, a company’s payout ratio paints a picture of how likely the company is to increase its dividend going forward. The smaller the payout ratio, the more of a “cushion” the company has to maintain, or preferably grow, its dividend over time.

The payout ratio can also serve as an indicator of whether the company is likely to cut or discontinue its dividend. The higher the payout ratio, according to Carlson, the greater the possibility that a company may have to cut or suspend its dividend should earnings fall. As a result, Carlson suggests avoiding stocks with payout ratios greater than 60%. While this limit may eliminate stocks in industries that, traditionally, pay out a large percentage of earnings as dividends, Carlson feels that stocks with such high payouts ratios also have higher risk.

In the advanced BSD model, the payout ratio carries a 30% weighting. Based on Carlson’s comments regarding the payout ratio, we would expect companies with very low payout ratios to receive the highest scores, since they are seemingly better positioned to increase their dividend over time.

Interest Coverage

Interest coverage measures how well a company’s profits cover its interest payments. If a company carries too much debt, it may be forced to lower or discontinue its dividend in order to make its interest payments.

One measure of interest coverage is times interest earned. In Stock Investor Pro, times interest earned is the sum of pretax income and interest expenses (operating and non-operating) divided by total interest expenses (operating and non-operating). The higher this ratio, the more apt a company is to be able to handle its interest payments without having to cut or discontinue its dividend payment. Interest coverage receives a 10% weighting in the advanced BSD formula.

Cash Flow to Net Income

While earnings get a lot of attention from investors and the financial press, they are a function of accounting rules and management assumptions. As a result, earnings can be subject to manipulation, as several high-profile scandals over the years have proven. Companies that are generating strong earnings on paper can still fail if they are not generating adequate cash flow.

Furthermore, companies pay dividends from the cash they have on hand. Therefore, in order to also maintain or grow their dividend over time, a company must generate adequate cash flows.

In his book, Carlson defines cash flow as net income after taxes plus noncash charges such as depreciation and amortization. This is the starting point for cash from operations, but leaves out adjustments for changes in working capital (e.g., changes in current assets and current liabilities). Since cash from operations is readily accessible in a company’s financial statements, we chose to use it in our advanced BSD screen.

Cash flow to net income shows the relationship of cash to profits. The higher the percentage, the more confident we can be as to the “legitimacy” of a company’s earnings. Cash flow to net income receives a 5% weighting in the advanced BSD formula.

Dividend Yield

Throughout his book, Carlson describes dividend yield (dividends per share divided by earnings per share) as a proxy for investment risk. He points out that investors should be leery of stocks with dividend yields that greatly exceed yields of companies in the same sector or industry, yields of the overall market, or the stock’s own long-term historical average yield.

Despite these warnings, Carlson uses dividend yield in the advanced BSD formula, with higher dividend yields receiving higher scores. However, he only gives it a 5% weighting.

Six-Month Relative Strength

Relative strength measures a stock’s price performance relative to an index. Carlson uses it in the advanced BSD formula because he claims that stock prices tend to bottom out before a company cuts or discontinues its dividend. Therefore, the higher the relative strength, the greater the likelihood that the company’s dividend is (relatively) secure.

Carlson assigns relative strength a 10% weighting in the advanced BSD formula.

Tangible Change in One-Year Book Value

Book value has been a popular measure of a company’s intrinsic or “real” value since the days of Benjamin Graham. A company’s “tangible” book value focuses on the hard or real assets of the firm. Intangible assets, such as goodwill, are harder to value and may artificially inflate a company’s book value. By measuring the change in a company’s tangible book value, according to Carlson, we are focusing on increases in book value “because of growth in retained earnings and other measures relevant to dividend safety.” The more the growth in book value is driven by the increase in tangible assets, the better.

The tangible change in one-year book value receives a 10% weighting in the advanced BSD formula.

Long-Term Expected Earnings Growth

As we mentioned earlier, a company pays its dividends out of cash, and cash flow growth is driven, in part, by growth in earnings or profits. Therefore, a company’s ability to increase its dividend over time depends largely on its ability to increase profits. Many services, such as I/B/E/S, the provider of earnings estimate data for Stock Investor Pro, poll analysts to arrive at a consensus earnings growth forecast over the next three to five years. The greater the expected growth in earnings going forward, the better the chances are that a company will increase its dividend over time.

Long-term expected earnings growth receives a 10% weighting in the advanced BSD formula.

Three-Year Cash Flow Growth

Unlike expected earnings growth, the last three elements of the advanced BSD formula are backward-looking. In this case, three-year cash flow growth shows how well a company has been able to grow its cash flow. While past performance is no guarantee of future results, Carlson is encouraged by companies that are able to increase their cash flows over time. Again, we are using a slightly different calculation of cash flow than that outlined by Carlson in his book. However, cash from operations is a value readily available for companies that file financial reports.

Three-year cash flow growth receives a 5% weighting in the advanced BSD formula.

Three-Year Dividend Growth

Just because a company has been able to increase its dividend over the last few years does not necessarily mean it will continue to do so. However, a company with a record of consistent dividend increases tends to follow that pattern. For this reason, Carlson gives thee-year dividend growth a 10% weighting in the advanced BSD formula.

Three-Year Earnings Growth

The final metric Carlson uses for his advanced BSD formula is three-year earnings growth. As with cash flow and dividend growth, a history of increasing earnings doesn’t guarantee that earnings growth will continue going forward. However, a company that has a history of earnings increases is more desirable than one that doesn’t.

Three-year earnings growth receives a 5% weighting in the advanced BSD formula.

Creating the Advanced BSD Screen

The Quadrix score, which plays a pivotal role in the basic BSD formula, is proprietary in nature, and so is the advanced BSD score. Although Carlson provides the weightings for the 10 metrics used in the advanced BSD formula, there is still a lot of room for interpretation. You can go to the Big Safe Dividends website (www.bigsafedividends.com) to see the Quadrix and BSD rankings for the S&P 1500 (Figure 1), but we are interested in seeing if we can mimic this approach for the entire stock universe.

For our version of the advanced BSD screen, we began by looking at the range of values for each variable using Stock Investor Pro with data as of August 12, 2011. We confined ourselves to a universe of stocks with the following characteristics:

• Exchange-listed (stocks trading over the counter are excluded);
• Not in the miscellaneous financial services industry (to eliminate closed-end funds and the like);
• A dividend payout ratio no higher than 60%; and
• Expected to pay a dividend over the next 12 months (indicated dividend is positive).

As of August 12, 2011, this left us with a universe of 1,284 companies.

Table 1 shows the data ranges for each of the 10 advanced BSD variables as well as the median and average values from our stock universe.

Based on these figures, we assigned scores to the data ranges for each variable, which are shown in Table 2. Again, this is a somewhat subjective endeavor; however, we let the data ranges for each metric guide us. In most cases, we assigned a score of 0, 1, 3 or 5. For each metric, a score of 3 was awarded for values around either the median or average. It is probably worth pointing out that, when assigning the data ranges for the various scores, we assumed that they were not normally distributed. You will also find the individual weights for each variable in Table 2. [For a greater level of precision, we will investigate how Excel’s percentile ranking function can be used for such analysis in a future installment of Spreadsheet Corner.]

Once we assigned the scores for each advanced BSD variable, we then created a composite score, where the score for each individual metric was multiplied by its respective weighting. A stock’s advanced BSD composite score can range from 0 to 5. In order to pass our advanced BSD screen, a company from our investable universe must have a composite score of 4 or higher (Carlson looks for companies with BSD rankings in the top 20%).

In addition, in order to pass our advanced BSD screen, a company must have a valid (non-null) value for all 10 advanced BSD variables. Looking at the Big Safe Dividends website, it appears that stocks could still be assigned a BSD score if this was not the case. This is likely one of the reasons why so few companies pass our screen compared to the listing you find at Carlson’s website.

Eleven companies passed our advanced BSD screen as of August 12, 2011.

Recreating Carlson’s work in Stock Investor Pro required creating numerous custom fields. If you are a Stock Investor Pro subscriber and are interested in the formulas used for this screen, you can download a supplement to this article below.

 

Overview of Passing Companies

Table 3 lists the 11 companies with an advanced BSD score of at least 4 as of August 12, 2011. They are ranked in descending order by advanced BSD score. RPC, Inc. (RES), an oil holding company, has the highest advanced BSD score at 4.4, while five stocks meet the minimum score of 4.0.

Table 4 presents summary statistics for the 11 companies passing our advanced BSD screen as well as for all exchange-listed stocks.

Dividend-paying stocks, in general, tend to have lower valuations than non-dividend-paying stocks. Looking at the price-earnings ratio for our passing companies, we see that it is slightly lower than that of the typical exchange-listed stock (12.9 versus 14.9).

Also, the typical stock does not pay a dividend (just over one-third of the companies in the Stock Investor Pro database pay a dividend), whereas Carlson’s BSD approach seeks out dividend-paying stocks. As a result, the median dividend yield for the passing companies (1.0%) is greater than that of the typical exchange-listed stock. Copa Holdings, S.A. (CPA), a Latin American airline holding company, has the highest dividend yield among the 11 passing companies at 2.6%. Education services company DeVry Inc. (DV) has the lowest dividend yield among the passing companies at 0.5%.

Interestingly, the median payout ratio for the passing companies—6.6%—is only slightly higher than that for exchange-listed stocks that pay a dividend, which is 4.2%. Ross Stores, Inc. (ROST) has the highest payout ratio among the passing companies at 13.9%.

The stocks passing our advanced BSD screen have been able to increase earnings at a strong pace over the last five years. On average, the companies have been growing their earnings by almost 28% over the last five years. By comparison, the median earnings growth rate for exchange-listed stocks is only 1.1% over the last five years. Dividend growth among the passing companies has been equally strong over the last five years, averaging almost 24%.

The median size of the companies passing our advanced BSD screen towers over that of the typical exchange-listed stock—$8.4 billion versus $414.4 million.

Lastly, the passing companies have been enjoying strong price momentum over the 52-week period ending August 12, 2011, outperforming the S&P 500 by 21%, while exchange-listed stocks have underperformed by 5%.

Conclusion

We have now discussed two different methodologies for identifying stocks with safe and increasing dividends that have the potential for price appreciation. The first was primarily based on proprietary factors available online. For this article, we used AAII’s Stock Investor Pro software to analyze the data ranges of the 10 factors used in Carlson’s advanced BSD formula and then assigned scores based on these data ranges to arrive at a composite advanced BSD that attempts to replicate Carlson’s analysis. As mentioned earlier, in the future we will attempt to use Excel’s percentile ranking function to better hone the scoring process.

No matter what tools you use to arrive at a set of passing companies, remember that this is only the first step in the analysis process. It is important to perform your own due diligence to make sure any investment you purchase meets your own risk tolerances and time horizon.