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Updated daily. All values annualized from Jan. 2008.

An interesting aspect of Joel Greenblatt's Magic Formula Investing (MFI) strategy is that its precepts can be applied to a variety of other stock strategies and focuses, as well. For example, if you like to invest in small caps, MFI can be used to find some good, undervalued businesses in a sector that is under-followed by professional equity analysts (here is an example). If you are looking to invest in foreign markets, MFI can be applied to stocks in foreign exchanges, and so forth.

We can also go the other way, and apply additional criteria to stocks in the official MFI universe. In theory, doing this starts with a list of good, undervalued companies, weeding out a lot of junk from the beginning. This article will focus on combing through the 3 screens covered by MagicDiligence (top 50 over 50 million and 1 billion, top 30 over 3 billion), looking for MFI stocks that may interest those who follow a long-term dividend-focused investing strategy.

The long-term part is important. Successful, sustainable dividend investing requires that prospective investments have certain attributes:

1) The starting dividend yield should be above or at least comparable to alternative fixed-income investments. Currently, interest rates are very low, with 1-year CDs averaging about 1.5%, generous money market accounts under 1%, and both 10-year treasuries and AAA bonds yielding about 3.5%. Since a good dividend stock should be able to grow its dividend *and* its capital value, I've set the minimum starting dividend yield at 4% for this exercise.

2) The current yield is sustainable for the forseeable future. Yes, there are a few MFI stocks with very high current yields, like Cherokee (CHKE) at 12% and Vector Group (VGR) at 11%. While those yields may hold for a year or so, both companies pay out well over 100% of free cash flow in dividends, not a sustainable situation. I'm looking for stocks that pay out 80% or less of free cash flow in dividends, which provides both sustainability and the potential for growth. Which leads us to...

3) Reasonable expectations of dividend hikes. There are a number of things that can give us confidence here. One was already mentioned - a comfortable payout ratio. Other contributors include a good balance sheet with manageable debt levels, a stable business with reliable cash flows in good times and bad, a history of consistent dividend hikes, and a solid competitive position.

4) Reasonable expectation of capital appreciation. MFI is a good screen for this, mechanically finding stocks that are cheap against past earnings. But we want to avoid businesses in run-off mode that simply pay out their free cash flow until revenues dry up. Some modest growth potential is required.

With these criteria in mind, here are 5 current Magic Formula stocks that may interest long-term dividend investors:

Reynolds American (RAI)

Current Forward Dividend: 3.60 (6.80% yield)
Free Cash Flow Payout Ratio: ~77%
Dividend History: Raised every year since going public in 2004.
Earnings Yield: 13%

Reynolds is the second-largest tobacco maker in the U.S., with cigarette brands like Camel and Pall Mall, and smokeless brands like Kodiak. Competitive dynamics are strong, as oppressive government regulation in the U.S. shuts out new competitors and hurts discount labels more than premium brands. While there is not much organic growth, market share gains on the premium end and strong R&D efforts around smokeless products should keep Reynolds chugging along, raising the dividend and buying back shares. Up-label cigarette companies are historically outstanding dividend investments.

Eli Lilly (LLY)

Current Forward Dividend: 1.96 (5.50% yield)
Free Cash Flow Payout Ratio: ~54%
Dividend History: 42 consecutive years of raises, 124 straight years of dividend payments.
Earnings Yield: 15%

Eli Lilly is a good-looking dividend play at current prices. The company is one of the largest pharmaceutical makers in the world, with products like Cymbalta for depression and antipsychotic Zyprexa. Payout ratio is modest and Lilly has a stellar dividend record. Some concerns are a high debt load after purchasing ImClone in 2008 and a large patent cliff in 2011. However, strong cash flow, a solid pipeline of new drugs, and ongoing cost cutting should keep the dividend going up for the forseeable future. At a 15% earnings yield, there is also significant capital appreciation potential if the R&D pipeline can deliver. Like tobacco, branded pharmaceuticals also have an outstanding long-term investment record.

Hillenbrand (HI)

Current Forward Dividend: 0.75 (4.20% yield)
Free Cash Flow Payout Ratio: ~40%
Dividend History: None. Spun off with current dividend in 2008.
Earnings Yield: 14%

Hillenbrand owns casket brand Batesville, long the market leader. This is a stable, predictable business - death knows no recession and competition is an oligarchy with new competitors unlikely. Dividend hikes and share buybacks are almost a given. Revenue growth potential is very limited, meaning management will have to provide shareholder returns by paying out cash flow. The current payout ratio is low, leaving plenty of potential for future dividend hikes, and Hillenbrand has no debt to pay down. The probability of stock price appreciation is modest. While the earnings yield is high at 14%, organic growth will probably be flat to slightly negative due to the long developing trend towards cremation and away from more expensive burial.

Update 1/29/10: Hillenbrand in January announced intentions to purchase industrial conveyer maker K-Tron for $433 million, much of it financed in debt. That completely changes the dynamics for this company and should probably eliminate them from a dividend investor's consideration.

Lorillard (LO)

Current Forward Dividend: 4.00 (5.20% yield)
Free Cash Flow Payout Ratio: ~78%
Dividend History: Little. Spun off from Loews (L) in 2008, has raised dividend twice since then.
Earnings Yield: 13%

Lorillard is another U.S.-based premium cigarette maker, a near pure-play on the Newport menthol brand. Lorillard has been constantly gaining share from Altria's (MO) Marlboro Menthol and Reynolds' Kool brands. The company also has the strongest balance sheet and highest operating margins in the tobacco sector. Much of the same dynamics outlined for Reynolds apply here, although Lorillard has no smokeless products to fall back on should the government and FDA get even more onerous with regulations.

United Online (UNTD)

Current Forward Dividend: 0.40 (5.80% yield)
Free Cash Flow Payout Ratio: ~25% ttm
Dividend History: Spotted. Dividend was cut last year due to FTD purchase, raised 2 years prior.
Earnings Yield: 17%

United Online is a mini-conglomerate consisting of one declining business in NetZero/Juno, one flat business in Classmates.com, and one with decent potential in FTD. This one is the most questionable of the 5. NetZero/Juno are in runoff mode, producing nice but declining cash flows as the dial-up Internet business dwindles. Classmates.com has held up pretty well but faces the onslaught of Facebook as a free alternative. FTD should provide good stability for a long time, although it does face heavy pricing competition. I like UNTD for its high current yield, very low payout of cash flow, and significant stock price potential considering the earnings yield is a dirt cheap 17%. On the down side, the company has 3 times more debt than cash on the balance sheet and relies on two declining businesses for close to 60% of income.

Steve owns no position in any stocks discussed in this article.

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