An income screening approach outlined in the "Little Book of Big Dividends" that is focused on stocks with low dividend payout ratios as well as nine other fundamental (and momentum) based criteria.
Charles Carlson is the CEO of Horizon Investment Services, an investment advisory business, and Horizon Publishing, a publisher of investment newsletters. Horizon's flagship publication, Dow Theory Forecasts, is one of the longest-standing investment newsletters in the US.
In his enjoyable 2010 book, "Little Book of Big Dividends", he outlines a quantitative system for income-hungry investors looking to construct a portfolio that generates big, safe dividends easily through his BSD (Big, Safe Dividends) formula.
How It Works
In the book, Carlson discusses two approaches - the basic BSD formula and the Advanced BSD version. We focus in this article on the Advanced BSD version.
This is because, other than the payout ratio, the basic formula relies entirely on what he calls the Quadrix® ranking system. Quadrix is a somewhat "black box"-ey quantitative scoring system which ranks stocks based on more than 100 different variables across six categories, including Momentum (e.g. growth in earnings, cash flow, and sales), Quality (e.g. return on equity & return on assets), Value, financial strength, earnings estimates & relative stock price performance. The idea with Quadrix is to focus on stocks that score in the upper quartile (75 and above out of 100).
While these rankings are available for US stocks, they are not available for foreign stocks. As a result, we focus on the Advanced Formula since that provides a lot of interesting quantitative "meat" that can easily be measured for UK stocks.
The Advanced BSD formula uses the following 10 fundamental and momentum factors with different weightings for each factor to arrive at a composite BSD score.
- Payout Ratio (30% Weighting) - In Carlson's methodology, the most important criterion (making up almost a third of the total weight) is the dividend payout ratio – the annual dividend divided by the earnings per share. He sees this as a powerful tool for spotting companies that can maintain and grow their dividends. A modest payout ratio gives the company the ability to maintain its dividend even if earnings happen to hit a rocky patch.
- Interest Coverage (10% Weighting) - This is considered an important factor as companies with lots of debt may struggle to pay the dividend if business conditions deteriorate. Interest coverage measures how well a company profits cover its interest payments. This ties in with research by Benito & Young for UK firms which found that the level of indebtedness is highly predictive of negative dividend changes.
- Three Year Dividend Growth (10% Weighting) - Carson recognises that, just because a company has boosted its dividend regularly, this doesn’t mean it will do so in the future. Nevertheless, he rightly observes that companies that have a history of raising their dividend on a regular basis tend to continue to do so (dividends are "sticky").
- Long Term Expected Growth (10% Weighting) - This metric looks at expected profit growth based on the earnings estimates of analysts who follow the company. While not a perfect measure given the poor record of analytst forecasting, he clearly feels that it is a reasonable way to get some view on a firm’s future profit growth prospects.
- Tangible Change in Book Value (10% Weighting) - This is used as a check on a company’s balance-sheet quality. Is book value increasing because of growth in retained earnings and other measures relevant to dividend safety, or because of an increase in intangibles like goodwill that may hard to value accurately?
- 6 Month Relative Strength (10% Weighting) - This metric measures the stock’s relative price performance over the last six months. While this is a technical rather than fundamental measure, he notes that stock price movements are anticipatory, i.e. stocks tend to crater prior to dividend cuts or omissions (On a related note, although not covered by Carlson, there has been some interesting research by Doran et al over the 2008/09 crisis which found that implied dividends from option prices have power to predict dividend cuts and omissions, although this type of approach is not feasible for small firms without traded options or with poor option liquidity).
- Cashflow to Net Income (5% Weighting) - While profits can be seen as the primary funding source of dividends, you need actual cash to pay the dividend. Interestingly, according to Carlson, cash flow should be calculated by adding noncash charges (such as depreciation) back to net income after taxes, although presumably cash-flow from operations (CFO) would be a good proxy too.
- Three Year Cash Flow Growth (5% Weighting) - While this is a backward-looking metric, he feels that there is something to be said for companies that have a record of boosting cash flows on a regular basis.
- Three Year Earnings Growth (5% Weighting) - Again this is a backward-looking metric but he wisely notes that he would much prefer betting on a company with a history of boosting earnings than one that does not.
- Dividend Yield (5% Weighting) - While he does include it as a minor factor, Carlson also warns against focusing overly on dividend yield as he sees this as a proxy for investment risk (i.e. stocks that yield above average vs. the industry, market or their own history may be in jeopardy).
Overall, that seems like a fairly comprehensive list of the factors likely to predict (or rather help avoid) a dividend cut but there are a number of surprising omissions. One factor is the size of the firm as research by Benito & Young has clearly shown that small firms are more likely to cut dividends "consistent with the notion that agency and signalling issues are more important for larger firms". Overall, this paper concluded that "Low levels of cash flow, high levels of income gearing and leverage, small scale and greater opportunities for investment are all associated with an increased propensity to omit a dividend".
In a similar vein, a useful study by Bulan and Subramanian also identified the significance for predicting dividend cuts of declines in Return on Assets, Sales Growth, Cash Holdings and the Price to Book ratio, all of which tend to display a U-shaped pattern around the time of a dividend cut. For dividend cutters, the capital intensity (i.e. capital expenditure divided by total assets) also is apparently high initially, declines sharply leading into the dividend cut, then recovers slightly thereafter -- indicating that firms are scaling back their investments.
Does the BSD Approach Work?
According to the book, Carlson has back-tested his approach to 1994. A hypothetical investor that bought all of the S&P 1500 stocks that were in the top 20% of the Advanced BSD screen and in the top 25% of his Quadrix ranking system, with annual rebalancing, would apparently have outperformed the S&P 1500 Index by more than 6% per year.
Where can I run this Screen?
The author provides a free website that calculates the BSD & Quadrix parameters for US Stocks. The website is updated weekly, and you can go check out the recommended dividend stocks at any time (it's free but you need to sign up).
If however you'd like to apply this methodology to UK stocks, we'll be setting up the Advanced BSD criteria shortly as part of the Stockopedia PRO stock screener, although we aren't going to model Quadrix as it is a proprietary system.
Quite apart from finding out more about the thinking behind the BSD system, it's worth reading "The Little Book of Big Dividends" as a useful introductory guide to dividend investing which highlights some important ideas. It is available on Amazon and it's also worth checking out the related website - http://www.bigsafedividends.com.
- Screening With the Big, Safe Dividend Formula: The Advanced BSD Approach
- Going Beyond Mere Dividends
- Hard Times or Great Expectations?: Dividend Omissions and Dividend Cuts by UK Firms
- Did Option Prices Signal the 2008 and 2009 Dividend Cuts and Omissions?
- Financial Pressure and Balance Sheet Adjustment by Firms
- A Closer Look at Dividend Omissions: Payout Policy, Investment and Financial Flexibility
Filed Under: Dividends,