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Desirable Dividends

Dividends are making a big comeback with investors and it's not hard to see why. Many blue-chip stocks are now paying more than GICs, government bonds or high-interest savings accounts. The tax advantages of Canadian dividends makes them even more attractive.

I've long appreciated a good dividend and many of my core holdings pay generous yields, but I'm getting a little nervous about some high yield stocks. Interest rates are at historic lows and my guess is that they're more likely to rise than to fall. If interest rates do rise then high yield stocks will be punished. Also, dividend stocks are not appearing as frequently on some of my stock screens which are pointing to more value in down trodden ex-growth stocks.

Investors seeking high dividend yield should make sure that the dividend is safe. Dividends that are not fully supported by earnings are at risk, but a margin of safety can be achieved when dividends are less than two-thirds of earnings. Investors should also demand that their dividend stocks be supported by strong balance sheets. For industrial companies this means low debt-to-equity ratios and lots of cash. Although each industry is a little different, a debt-to-equity ratio of less than one is usually a good sign. Companies with little in the way of real assets should have even lower ratios. For instance, debt laden software companies tend to be dangerous creatures. Debt that has to be repaid quickly can be catastrophic without suitable cash reserves. A stock's current ratio is a useful tool for measuring short-term cash needs. The current ratio is equal to a company's current assets divided by its current liabilities. Firms with more current liabilities than current assets are risky. Businesses with a current ratio of two or more are relatively safe.

Aside from safety, the dividend investor should consider a firm's growth prospects. It is important to remember that about half of the return from high yield stocks tends to come from capital gains. Although, I am unwilling to pay much for growth I like to see growth potential which leads me to consider smaller companies that are still able to expand. Companies that pay out less than half of their earnings in dividends and have a history of increasing their dividends are particularly interesting. Also, lower yielding stocks with a history of sales and earnings growth are desirable provided that the price isn't too high.

In the end, the most important factor to consider is price. There are a wide variety of tools to help investors estimate when a stock's price is reasonable. I like to use four simple ratios: the price-to-earnings ratio, the price-to-sales ratio, the price-to-cash flow ratio and the price-to-book value ratio. A low value for these ratios is good but special care must be taken when the ratios are very low. Unusually, very low ratios are a sign of acute stress. In such cases, extra patience and additional digging are required. When analyzing ratios look at historical patterns. For instance, the major Canadian banks have traded at price-to-book value ratios of between one and two. In the early 1990s, when the banks were on the ropes, even smaller price-to-book value ratios were common. With the major banks currently trading at price-to-book value ratios of between 1.6 and 2.3 it would appear that their valuations are a little on the rich side. Remember, a dear price can easily turn a supposedly safe investment into a stinker.

Two dividend stocks that I currently favor are:

Phillip Morris (MO on the NYSE, $38.32)

If you think that tobacco companies are evil incarnate then it's best to skip this one. If you like a dividend yield of 6.7%, with a long history of dividend increases, and massive stock buybacks then MO is a stock you should consider. Phillip Morris is by far the largest stock in my portfolio and it is on the risky side due to smoking related litigation and taxation. Even with no growth, MO's earnings yield of 13.9% is mighty attractive.

Buhler Industries (BUI on the TSX, $5.89)

Buhler has been growing sales for years in the difficult farm equipment business. Yet despite its strong growth record the stock remains reasonably priced with a P/E of 10.5 and a price-to-sales of 0.58. To top off a good price, Buhler pays a 2.0% dividend and has a moderate debt-to-equity ratio of 0.52. Since Buhler is a family-controlled small-cap stock it is suitable only for the more adventurous.

First published in January 2003.

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