Using the Magic Formula with a Dividend Strategy
One advantage to Joel Greenblatt's Magic Formula strategy is it's applicability to many other popular value based investing strategies. In this article, I'll show how an investor focused on building income through dividends can apply the MFI screen to find potentially attractive investments.
First, let's define what a dividend strategy is. Dividends are simply cash payments a company makes to it's shareholders. This concept is exactly the same as interest paid on a savings account, or yield on a bond. The main difference is that dividend payments are up to the discretion of a company's management and board of directors. Dividends can be cut or raised at any time.
Investors following a dividend strategy are looking to maximize the amount of cash income generated by their portfolio. In essence, a sizable portfolio can throw off enough in cash dividends to replace the income from a job! These investors are looking for a few things. One, a healthy dividend yield, usually 3% or higher. Two, a company that has reliable cash flows so that the likelihood of a dividend cut is minimal. Three, companies with a history of regular dividend increases and no dividend cuts. Usually, once this investment is found, the dividend investor will re-invest dividend payments into buying more shares of stock. By doing this, they receive increasing amounts of income due to two things: (1) more shares due to re-invested dividends and (2) more dividends on each share due to dividend hikes.
To illustrate the viability of this plan, let's take a look at a current Magic Formula stock paying a solid and sustainable dividend: Sherwin-Williams (SHW). Let's say we purchased Sherwin-Williams back in 2000 when it's dividend yield was about 2.75%. This company had a 20 year history of dividend hikes at the time, and predictably has continued to raise it's dividend every year. By reinvesting those payments, our yield steadily rose, and the effects of compounding accelerated until today Sherwin-Williams would be paying us nearly 8% on our original investment this year:
Assuming we continued this strategy, it is likely that this yield will continue to exponentially increase, so that by the time retirement rolls around (say, 20 years), our original investment could very well be paying us 50% of it's value, or more, annually, money that can go towards replacing working income.
So, how does the Magic Formula screen play into this? Well, the Magic Formula by design turns up stocks selling at very cheap prices relative to earnings. Often, this also means very cheap prices relative to dividend yields. Add this to the screen's design to find good companies (i.e. companies that can sustain a dividend), and you have a fertile field for potential income investments. Have a look at some current MFI dividend payers:
|Stock||Current Dividend Yield|
|Biovail Corporation (BVF)||15.2%|
|Gannett Company (GCI)||9.2%|
|Ambassador's Group (EPAX)||3.3%|
|Sherwin Williams (SHW)||2.9%|
If Sherwin-Williams can build up to an 8% yield from a 2.75% start in 8 years, imagine what starting at a 15% yield could build to!
Of course, there is one other matter. These dividend payers must also have cash flows that can sustain these payouts. We also need to make sure that the company has a history of continually increasing dividends. This is where MagicDiligence comes in. By analyzing the cash flows and management histories of these dividend payers, we can find those MFI stocks most likely to deliver continually rising income from an investment.
Dividend strategies can be extremely attractive for very long term holders of stock. Does retiring on income from investments without even touching the principal sound attractive to you? Take a free trial today and find some great potential income generating investments.
Disclosure: Steve owns no stocks referenced here.
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