Five Screens to Protect Your Capital © Connolly Report October 2001 page 491
Every week, the Report on Business features lists in eight categories which they call "Best Buys". Included is a list of the TSE 300's top 20 yielding common stocks. I glance at it now and then. Some of the stocks in my list are in the Globe and Mail's list...most aren't. I don't consider many of these stocks "Best Buys". Why?
Over the years we have developed a number of screens or rules to protect us from our own stupidity and protect our capital. Unlike CSBs, there is no guarantee that you will get your money back with common stocks, but by following a few simple guidelines, you will have a very reasonable assurance. In view of the hazards in the market currently, I review these screens. Especially now, we must keep on the straight, narrow and secure path.
STOCK PAYS A DIVIDEND Purchasing only stocks which pay dividends saves us from all kinds of horrors. It was not too long ago, remember, that "investors" were paying big money for companies that didn't even have earnings, let alone dividends: the exuberance was irrational. Investors are now buying dividend-paying stocks again. As Peter Lynch says, "The dividend is such an important factor in the success of many stocks that you could hardly go wrong by making an entire portfolio of companies that have raised their dividends for 10 or 20 years in a row."
REASONABLE YIELD The common stocks near the top of the Report on Business yield list are not "Best Buys": their yields are too high. What's too high? Over the years I have found that great caution has to be exercised if a stock has a dividend yield more than half a point (50 basis points) above stocks of similar nature.
When a yield gets too high, it means the company is out of favour for some reason and/or that the dividend is in danger. The reason must be investigated. Telus is an excellent example from the current list. The market is waiting for a dividend reduction and has priced T to take this into account. Usually, once a dividend cut announcement has been made, the price firms and the long road to recovery begins.
DIVIDEND RECORD Sticking to stocks with a recent dividend increase is an excellent way to safeguard capital. As John Markese of the American Association of Individual Investors says, "...an increase in the annual cash dividend is a strong, positive statement by the firm that they believe future earnings, liquidity and financial position warrant the dividend increase." In addition to a recent dividend increase, look to a long record of dividend payments (at least a decade) and a good five year dividend growth record. Canadian Utilities, for instance, has increased its dividend in every year since CU was formed as a holding company in 1973.
PAYOUT RATIO Dividends are paid from earnings. Be certain earnings are sufficient for the company to pay increasing dividends. The average payout ratio of stock is my list is now 52. Especially now, with declining earnings in many sectors of the economy, check the payout ratio. Is the payout ratio near normal for this company, and its industry?
RATING CHANGE Before a major new purchase, I always check the rating of a company's debt with data from a credit rating agency. With the internet, this is easy to do (http://dbrs.com). I check what the rating is on various forms of debt and check if there has been a recent change: "stable" is good. Usually, I go a step further: I seek out a library that carries the full DBRS reports and carefully study the two or three page write up on the company. The credit rating agencies, unlike most brokerage research reports, point out the weakness in a company's position too...DBRS calls them "challenges".