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(Nikolay Neveshkin)
(Nikolay Neveshkin)

Portfolio Strategy

10 dividend stocks for safety-conscious bargain hunters Add to ...

The bear market is back and Canadian investors have the claw marks to prove it.

The S&P/TSX composite is now down just over 20 per cent from its highs of early 2011. The European financial crisis and China’s slowdown have taken a bite out of portfolios and continue to stalk the market.

Fortunately, there is good news even during a rough patch like this. Lower prices can be an opportunity for bargain hunters. In fact, a bear market can be an excellent time to track down a few juicy dividend stocks while they’re on sale.

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To guide us in our hunt, let’s follow the path of conservative dividend investors – a group that has historically done quite well over the long haul.

Investors of this type tend to stick to larger companies because big guys tend to be more stable than small fry, which have the disconcerting habit of swooning after every economic twitch.

When it comes to size, I think it’s good to employ a two-stage test. Start by looking for firms with market capitalizations in excess of $500-million, then search for those with revenues of $500-million or more. Each factor weeds out slightly different stocks and they work well in combination. For instance, by demanding large revenues you effectively eliminate many speculative junior mining concerns from consideration.

You can get a full list of large Canadian common stocks that trade on the TSX by taking a quick trip to globeinvestor.com's stock filter. If you do so this weekend, you’ll likely find more than 200 stocks that pass the dual size test.

With such a long list of large Canadian stocks in hand you can develop a good sense of the dividend yields on offer. To form a picture of the dividend landscape, I’ve sorted all the stocks into groups based on their yields; I’ve then added up the number of stocks in each group. The result is displayed in the accompanying graph, which shows the distribution of large Canadian stocks by dividend yield.

Dividend investors should be pleased that most large Canadian stocks pay dividends because that diversity allows for a good deal of choice when it comes to selecting the best ones for your portfolio.

It’s relatively easy to find stocks with yields near 5 per cent, which seems quite generous these days when the yield on long-term government bonds is only about 2.5 per cent. But proceed cautiously when it comes to stocks with extremely large dividend yields. These stocks deserve additional care because an unusually high yield can be a sign that a company is in distress or under pressure. A high yield often indicates that the market is worried about a firm’s prospects and suggests that a dividend cut may be in the offing.

The exact dividing line between a high yield and an extreme yield is a matter for debate. But stocks with yields in excess of about 6 per cent are ringing alarm bells at the moment. You should be sure to study such stocks intently before buying them.

For safety’s sake, it’s a good idea to stick to stocks with generous but not extreme yields. These days that means something in the 4-per-cent and 6-per-cent range. As it happens, there are about 50 such stocks to choose from – enough to give you considerable latitude in choosing ones that will fit your portfolio.

Assuming you’re an investor who wants safety, you should start by examining each firm’s earnings for reassurance that it can pay its dividend. That means looking for companies that earn more than they pay out in dividends. After all, if a firm consistently pays out more than it earns, it will eventually be forced to cut its dividend.

But while healthy earnings tilt the odds in your favour, they’re no panacea. Consider the unfortunate case of Yellow Media . At one time the firm generated copious earnings and paid a sizable dividend to investors.

Alas, the firm’s business was undermined by competition from the Internet. Its stock now trades for pennies a share and management eliminated the dividend months ago. The lesson here is that it is important to pay attention to more than just the numbers and to consider the less tangible aspects of a stock before buying it.

At this point, I like to turn to Benjamin Graham, the father of value investing, for some advice. Mr. Graham, who was a mentor to Warren Buffett, suggested that defensive investors stick to stocks with price-to-earnings ratios (P/E) of 15 or less and price-to-book-value ratios (P/B) of 1.5 or less.

Both ratios are classic value metrics. When buying low-P/E stocks you are trying to get lots of earnings for a low price. Low-P/B stocks offer copious net assets (based on their balance sheet values) at low prices. Since Mr. Graham suggested sticking to low-ratio stocks more than 60 years ago, many performance studies have backed him up.

Following Mr. Graham's recommendations, along with the previous criteria, leads to the 10 stocks listed in this accompanying infographic. They all get high marks for both their generous dividend yields and value characteristics.

Will these stocks fare well in the future? I have high hopes for them, but the market isn’t that predictable. After all, such screens are just the starting point for further research and you should consider each stock’s less tangible features before buying. But, for what it’s worth, I own several and may well add a few more to my personal portfolio in the future.

Norman Rothery, PhD, CFA is founder of StingyInvestor.com

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