h d Quarter 2011

Third
www.computerizedinvesting.com Volume XXX, No. 3

New Weekly Email Feature:

Editors Outlook Screening With the Big,
Safe Dividend Formula

At the end of April we launched a new weekly CI

email to give our readers more timely and frequent M any investors seek income to supplement their
portfolio returns while at the same time insulating
themselves from market declines. In The Little Book of
reviews of useful websites, software and tech gadgets.
In addition, each week we delve into CIs archives to Big Dividends: A Safe Formula for Guaranteed Returns
nd timeless articles that you might have otherwise (John Wiley & Sons, 2010), Charles Carlson outlines a
missed. Our reader survey questions give you a chance recipe for investment success:
to interact with us and answer questions related to your Find stocks with above-average appreciation potential
computer, technology and investing habits. We will still and safe and growing dividends, and buy them at attrac-
publish periodic online exclusive articles, including our tive prices.
popular annual PC Buyers Guide and our annual com- Carlson believes investors can achieve this success
parison of comprehensive nancial websites. If you had by using proprietary ratings, which he makes avail-
already signed up for the former monthly CI email, you able online for free. In this article, we discuss Carlsons
should be receiving the new weekly CI email, which is investment philosophy and then introduce his proprietary
sent out each Saturday morning. If you are not receiving ratings to narrow down the stock universe to a more
the CI email, log into your account at AAII.com and go manageable collection of dividend-paying stocks.
to My Account. There you can sign up for a number
of AAII emails, including the weekly CI email. Why Dividends Matter
Sharing AAII Content When investing in stocks, we get paid in two ways
Recently a comment was left online regarding a CI with capital gains and with dividends. Combining the
article discussing the sharing of CI and AAII Journal ar- two gives us a stocks total return. While it is easy to get
ticles with non-members (you can nd the comment in caught up in the daily movement of stock pricesthe
the Messages section on page 3). The reader voiced con- (continued on page 16)
cern that such sharing dilutes the value of AAII mem-
bership and subscriptions to Comput-
erized Investing. I am a proponent of
social media, being an active partici- Updates Fundamental Focus
pant through my Twitter feed and the
CI Facebook page. While it is true Macroaxis .....................................4 How to use profit margins
that article sharing gives non-mem- Zignals ..........................................5 to judge a stock......................... 20
bers access to members-only content, TradingSolutions ..........................6
such sharing is an excellent way to
BudgetPulse .................................7 Comparison
spread AAIIs message of unbiased
investor education. The hope is that The best software and websites
through this sharing we will be able On the Internet for mutual fund screening....... 22
to increase our subscriber base, Company financials .................. 10
which gives us additional resources
to build upon AAIIs mission to the
Technically Speaking
benet of all members and readers. Spreadsheet Corner Measuring volatility with the
Since there is the possibility of abuse, Optimizing a portfolios risk/return average true range (ATR)........ 30
(continued on page 2) profile ......................................... 12
 Screening With thee Big
Big,
g,
g
Feature mula
m
Safe Dividend Formula
By Wayne A. Thorp,
rp, CFA
CFA

(continued from page 1) price. Most of the dividend yields yield is potentially too high, Carlson
capital gains element of total re- you see quoted in the nancial press suggests comparing it to the com-
turnit is important not to disregard or provided on nancial websites panys sector or industry yield; to the
the impact of dividends on this equa- are indicated yields, which are yield of the overall market, as repre-
tion. In fact, according to Carlson, calculated using the stocks indicated sented by an index such as the S&P
roughly 40% of the stock markets dividend instead of the last four quar- 500; or to the stocks long-term aver-
long-run total return comes from ters dividend. The indicated dividend age yield. When the yield is consider-
dividends. is calculated by annualizing the most ably higher than these benchmarks,
Despite the record number of com- recent dividend: If a companys last Carlson feels this to be a red ag of
panies that omitted or cut their divi- quarterly dividend was $0.25 per potential problems.
dends in 2008 and 2009
(Carlson points out that Seeking Dividend-
roughly one in eight S&P For Carlson, the most Paying Stocks
500 companies reduced or
eliminated their dividend
in 2008 and about 15%
important indicator of When seeking out divi-
dend-paying stocks, Carlson
did so in 2009), most rms stresses the importance of
are extremely hesitant to dividend safety is the payout evaluating dividends and
cut the dividend once they yields differently. He sug-
initiate a dividend policy.
For this reason, we tend to
ratiothe percentage of a gests that dividend investors
consider the following:
see larger, more established Safety and dependability
and mature companies pay- companys earnings that are of the dividend: Bigger
ing dividends. isnt always better when
For Carlson, the most
important indicator of divi-
paid out in dividends. it comes to dividend
yield. As we have stated,
dend safety is the payout Carlson views dividend
ratiothe percentage of a companys share, its indicated dividend would yield as a proxy for risk. A yield
earnings that are paid out in divi- be $1.00 ($0.25 four quarters). is useless if the company cant
dends. If a company has $1.00 per With a current share price of $20, support the dividend payment
share of earnings and pays out $0.50 the indicated yield would be 5% going forward. Carlson wants a
per share in dividends, its payout ra- ($1.00 $20). big dividend that is going to be
tio is 50% ($0.50 $1.00). All else However, Carlson cautions against around today, tomorrow and well
being equal, the higher a companys using yield as a primary screening into the future.
payout ratio, the more likely it is that lter. His reasoning is that yield is a Capital gains potential of the
the company will reduce or eliminate proxy for risk, with unusually high stock: Carlson isnt merely an
the dividend when problems arise. yields hinting at potential problems income investor. He is a total
Carlson goes as far as to say that the with the rm. For Carlson, the higher return investor. Therefore, he
payout ratio is the single most power- the dividend yield, the greater the does not ignore the capital gains
ful factor in analyzing the health, risk that the dividend will be omitted prospects of a stock. As he puts
stability, and growth potential of a or cut. it, a big yield is meaningless
stocks dividend. Carlson points out that a stocks in the face of signicant price
yield will rise because of two events: losses.
Dont Be Tempted by 1) the dividend increases and/or Yields on alternatives: When
Yield 2) the stock price falls. He views considering dividend yields,
yield as a proxy for risk because more Carlson cautions against getting
When looking for dividend-paying often than not, very high dividend wrapped up in absolutes. In-
stocks, many investors begin by yields are caused by falling stock stead, he suggests comparing the
focusing on stocks with the highest prices, not by rising dividends. A yield of a stock to those of other
dividend yields. The dividend yield of rapidly declining stock price is a very investments. Even if, in absolute
a stock is calculated by dividing the good indicator that there is some- terms, the yield seems low, the
total dividends paid out over the last thing wrong with a company. stocks yield may be favorable
year (last four quarters) by the share In order to determine if a stocks compared to the alternatives.

16 Computerized Investing

Yields on comparable invest-
ments: It is also a good idea to
compare dividend yields across
industry/sector and market
benchmarks. When you nd a
yield that is signicantly higher
than that of its industry or the
overall market, there is a strong
likelihood that this dividend is
about to go away.
Pretax versus aftertax yields:
Carlson reminds the reader that
it is important to consider both
the pretax and aftertax yields,
especially if you are holding in-
vestments outside of a retirement
account.
Dividend growth potential:
Lastly, Carlson stresses the im-
portance of seeking out dividend-
paying stocks generating the
best total returns over time. As a
result, you need to consider the
dividend growth potential of a
stock. However, he warns against
using your own personal income
needs in selecting dividend-
paying stocks. Just because you
need a 6% yield doesnt mean will eliminate stocks in industries
that you should be seeking out
stocks yielding 6%. Instead, he
advocates picking dividend-pay-
ing stocks on their merits. This
is why he doesnt use dividend
yield as a primary lter for
dividend-paying stocks. Instead,
he lters stocks based on pro-
prietary ratings that attempt to
gauge the total return potential
of a stock and uses yield only as
a secondary lter.
BSD Formula
In his book, Carlson introduces his
big, safe dividend (BSD) formula for
picking attractive dividend-paying
stocks. Actually, he discusses two
BSD formulas: basic and advanced.
However, for this article we focus on
the basic BSD approach, reserving
the advanced formula for a future
article.
Basic BSD Formula
Carlsons basic BSD formula is
Third Quarter 2011
based on two premises:
A company cannot pay dividends
if it doesnt have the money to
do so; and
You should choose stocks based
on their total return potential,
not just dividend return (yield).
His basic BSD formula uses two
data points to address these issues:
Payout ratio; and
Overall Quadrix score.
Payout Ratio
As we mentioned earlier, a stocks
payout ratio measures how much of
a companys prots (earnings) are
paid out as dividends. For Carlson,
the payout ratio is an indicator as to
whether a company can maintain and
grow its dividend. The smaller the
percentage of earnings a company
pays out in dividends, the more of a
cushion it has to grow the divi-
dend, or at least maintain it should
earnings decline.
For Carlson, a safe payout ratio
is anything below 60%. While he
admits that using an absolute cutoff
or higher out of a possible 100).
with historically high payout ra-
tios, he feels better knowing he is
also eliminating stocks with poten-
tially higher risk (as indicated by the
higher dividend yield).
Quadrix Score
The second element of Carlsons
basic BSD formula is the Quadrix
Scorea proprietary stock-rating
system developed by Dow Theory
Forecasts (now called Horizon
Publishing), the investment newslet-
ter publisher where Carlson works.
Carlson uses this multivariate system
to identify stocks demonstrating
balanced and broad growth. The
Quadrix system ranks over 4,000
stocks based on more than 100 vari-
ables across six categories:
Momentum (growth in earnings,
cash ow and sales),
Quality (return on investment,
return on equity and return on
assets),
Value (price-to-sales, price-earn-
ings and price-to-book ratios),
Feature
Financial strength (debt levels),
Earnings estimates, and
Performance (relative stock price
performance).
According to Carlson, some
variables are weighted more heavily
based on their past effectiveness. The
overall Quadrix score is a weighted
average of the six category scores.
However, the Quadrix stock rating
system is a black box, or propri-
etary, system, so Carlson does not go
into too many specics as to how the
score is calculated or the weightings
assigned to the different variables.
The Dow Theory Forecasts website
does offer some details as to how the
Quadrix Score is calculated (www.
dowtheory.com/quadrix_explained.
asp), but is still not explicit about its
construction.
The overall Quadrix score is a
percentile ranking, so a reading of 90
means that a stock scores better than
90% of the stocks in the Quadrix
universe. Carlson focuses on stocks
that rate in the upper quartile (those
with an overall Quadrix score of 75
To help investors, Carlsons website
(www.bigsafedividends.com) provides
the payout ratios and overall Quadrix
scores for all the dividend-paying
stocks in the S&P 1500 composite.
Access to the site is free, but you are
required to register using an email
address.
Basic BSD Formula Filters
Carlson goes on to describe a
simple stock-ltering system based on
his basic BSD formula:
Filter 1: Focus on stocks with pay-
out ratios of 60% or less.
Filter 2: Focus on stocks with over-
all Quadrix scores of 75 and higher.
Since the Quadrix scoring system
is proprietary, we used Carlsons free
website to do the ltering for us.
We found payout ratio and overall
Quadrix scores for the 887 stocks in
the S&P 1500 that pay a dividend
as of May 18, 2011. This is roughly
20% of the entire 4,000+ Quadrix
stock universe. While its a limited
17
 Feature

Table 1. Simple BSD Formula Screening Results

Payout
Price Dividend Yield Ratio Quadrix
Company (Ticker) ($) ($) (%) (%) Score Description
Intel Corp. (INTC) 24 0.73 3.0 33 100 semiconductor chips
Chevron Corp. (CVX) 103 3.12 3.0 30 98 oil & natural gas
International Paper Co. (IP) 32 1.05 3.3 37 97 paper & packaging
Abbott Laboratories (ABT) 54 1.92 3.6 45 94 health care prods
Lilly (Eli) & Co. (LLY) 39 1.96 5.1 41 94 pharmaceuticals
Comtech Telecommun (CMTL) 28 1.00 3.6 40 92 communications solutions
Olin Corp. (OLN) 23 0.80 3.5 39 92 industrial bleach prods
Lockheed Martin Corp. (LMT) 80 3.00 3.8 39 91 advanced tech sys for govt
Block H & R Inc. (HRB) 16 0.60 3.6 41 90 tax & business servs
Conocophillips (COP) 73 2.64 3.6 39 88 oil & natural gas
Cato Corp. Class A (CATO) 26 0.74 2.9 38 86 womens apparel stores
Northrop Grumman Corp. (NOC) 65 2.00 3.1 30 86 advanced tech sys for govt
Foot Locker Inc. (FL) 23 0.66 2.9 59 85 athletic footwear
PPL Corp. (PPL) 28 1.40 5.0 49 85 electric utility holding co.
Tompkins Financial Corp. (TMP) 40 1.36 3.4 43 83 bank holding co.
Superior Industries Intl (SUP) 22 0.64 2.9 32 82 aluminum vehicle wheels
Tower Group Inc. (TWGP) 24 0.75 3.2 25 81 insurance prods
M & T Bank Corp. (MTB) 89 2.80 3.1 47 80 bank holding co.
DPL Inc. (DPL) 30 1.33 4.4 56 79 electric utility holding co.
McDonalds Corp. (MCD) 82 2.44 3.0 52 78 value-priced restaurants
Strayer Education Inc. (STRA) 120 4.00 3.3 41 78 post-secondary education
Mattel Inc. (MAT) 27 0.92 3.4 50 76 toy manufacturer
Fidelity National Financial (FNF) 16 0.48 3.0 27 76 insurance holding co.
NYSE Euronext (NYX) 35 1.20 3.4 48 75 nancial markets operator
Dime Community Bancshares (DCOM) 14 0.56 4.0 44 75 bank holding co.

Source: Big Safe Dividends, www.bigsafedividends.com. Data as of May 18, 2011.

subset of the entire Quadrix universe,
this is a good starting point for those
looking to invest in dividend-paying
stocks.
We began by exporting the Web
table to Excel by right-clicking on the
table and selecting the Export to Ex-
cel menu option. Doing so allowed
us to manipulate the data more easily
than can be done with the Web table.
Once we had the data in an Excel
spreadsheet, we sorted the table for
those stocks with a positive pay-
out ratio less than or equal to 60%
(0.60). Of the 887 companies in the
listing as of May 18, 2011, 50 had
negative payout ratios and another 39
did not have a payout ratio listed. Of
the 798 remaining companies, 640
had a payout ratio no higher than
60%.
We then copied this pared-down
list of companies to a new worksheet
and sorted the remaining stocks in
descending order by their overall
Quadrix score. Here, we are looking
for Quadrix Scores of 75 or higher.
Of the 640 companies with payout
ratios between 1% and 60%, 238
had an overall Quadrix score of 75 or
above.
While we narrowed down the initial
database of 887 companies to 238,
this is still a rather unwieldy collec-
tion of stocks. As our nal sorting
criterion, we looked to the dividend
yield. Previously, we mentioned that
Carlson discourages investors from
using dividend yield as a primary l-
ter when looking for dividend-paying
stocks. But since we used the payout
ratio to isolate stocks that Carlson
judges have a safe dividend that is
likely to grow as well as those with
the potential for balanced and broad
strength, as indicated by the overall
Quadrix score, we can now use yield
as a secondary lter by highlighting
those remaining stocks with the high-
est dividend yields.
Overview of Passing
Companies
Table 1 lists the 25 stocks with the
highest dividend yields as of May
18, 2011, that have both a payout
ratio less than or equal to 60% and
an overall Quadrix score of 75 or
higher. These 25 stocks have divi-
dend yields ranging from a high of
5.1% [Eli Lilly & Co. (LLY)] to a
low of 2.9% [Cato Corp. (CATO),
Foot Locker Inc. (FL) and Superior
Industries (SUP)].
Foot Locker Inc. makes the nal
listing with its payout ratio of 59%,
just below the 60% cutoff. At 25%,
Tower Group Inc. (TWGP) has the
lowest payout ratio among these 25
stocks.
Finally, the overall Quadrix scores
for these 25 stocks range from a low
of 75, the hurdle score, for Dime
Community Bancshares (DCOM) and
NYSE Euronext (NYX), to a high of
100 for Intel Corp. (INTC).
Table 2 presents summary statistics
for the 215 stocks with a payout ratio
less than or equal to 60% and an
overall Quadrix score of 75 or higher.
Carlsons simple BSD formula
screen requires stocks to have payout
ratios no higher than 60%. The medi-

18 Computerized Investing

an payout ratio for the current group
of passing companies is 18.8%, while
the typical exchange-listed stock has
a payout ratio of 3.6%.
In order to receive a high value
score, the Quadrix system looks at
such ratios as the price-earnings,
price-to-sales, price-to-cash-ow, and
price-to-book ratios; dividend yield;
and price-earnings ratio relative to
expected earnings growth (forward
PEG). These ratios are compared to
the average level of the ratios over
the last three and ve years, and
stocks that are most attractively val-
ued relative to these historical levels growing rms. As
receive the highest value score.
The median price-earnings ra-
tio for the 215 companies passing
Carlsons simple BSD formula screen
as of May 18, 2011, is 15.5. This is
slightly lower than the price-earnings
ratio of the typical exchange-listed
stock, which is 17.6. The price-to-
book ratio of these companies is
2.5, which is higher than the 1.7 for
exchange-listed stocks. Furthermore,
as we mentioned earlier, most stocks
do not pay a dividend. Therefore, the
median dividend yield for exchange-
listed stocks is 0%, while the median
for these simple BSD formula stocks
is 1.5%.
To score high in terms of quality in same time period.
the Quadrix system, a company must
demonstrate strong growth in sales,
earnings, cash ow, common equity,
and dividends over the last one, three
and ve years. The stocks passing
the simple BSD formula screen as of
Wayne A. Thorp, CFA, is editor of Computerized Investing and
is AAIIs senior financial analyst. You can follow him on Twitter at
www.twitter/ci_editor.
Third Quarter 2011
Feature
May 18, 2011, have Table 2. Simple BSD Formula Portfolio Characteristics
a median ve-year
historical earn- Simple BSD Exchange-
Formula Listed
ings growth rate Portfolio Characteristics (Median) Screen Stocks
of 10.3%, which Price-earnings ratio (X) 15.5 17.6
dwarfs the median Price-to-book-value ratio (X) 2.5 1.7
growth rate of 3.5% Dividend yield (%) 1.5 0.0
for exchange-listed Payout ratio (%) 18.8 3.6
EPS 5-yr. historical growth rate (%) 10.3 3.5
stocks. Our start- EPS 3-5 yr. estimated growth rate (%) 11.7 12.6
ing universe was Dividend 5-yr. growth rate (%) 9.4 0.0
dividend-paying Market cap ($ million) 6,459.9 554.6
constituents of the Relative strength vs. S&P* (%) 8 (3)
S&P 1500, which
*S&P 500 index = 0.
tend to be more Source: AAIIs Stock Investor Pro/Thomson Reuters. Data as of May 13, 2011.
mature, slower-
a result, we see a projected earnings have outperformed the S&P 1500 in-
growth rate for the next three to ve dex by an average of four percentage
years lower than that of the typical points a year from the end of 1994
exchange-listed stock (11.7% ver- through 2009, and with lower risk
sus 12.6%). The ve-year dividend than that of the index.
growth rate for the simple BSD
formula stocks is 9.4%. Conclusion
Looking at performance, the
Quadrix system places a premium on Charles Carlson is a total return
strong short-term performance from investor looking for stocks providing
two to 12 months. The stocks cur- income in the form of safe dividends
rently passing Carlsons simple BSD that he expects to grow over time,
formula screen have outperformed as well as a strong nancial founda-
the S&P 500 index by 8% over tion to generate price gains. He uses
the last 52 weeks, while the typical his companys Quadrix stock rating
exchange-listed stock has underper- system to lter the dividend-paying
formed the index by 3% over the stock universe to nd such candi-
dates.
It is impossible for us to indepen- Quantitative systems such as
dently test the performance of Carl- Carlsons are excellent ways for
sons simple BSD formula. According investors to hone in on attractive
to his book, a portfolio of stocks investment candidates that warrant
meeting these criteria, rebalanced at additional analysis. However, quanti-
the beginning of each year, would tative stock selection systems are only
one piece of the selection process. A
qualitative element is equally impor-
tant. For this reason, investors must
still perform their own due diligence
to make sure the investments they
select meet their own time horizon
and risk tolerances.
19