Wanted: Dividend stocks with room to grow

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What are we looking for?

Merrill Lynch's equity strategy team says dividend-focused investing strategies were big outperformers in 2011 – and should be again this year.

"We still favour this theme, as we believe the dynamics of low supply (record low dividend payout ratios, protracted low interest rate environment) and high demand (retiring Baby Boomers swapping growth for income, search for yield among pension funds, etc.) will persist for the foreseeable future," wrote Savita Subramanian, head of U.S. equity and quantitative strategy, in a recent report.

Ms. Subramanian particularly likes a dividend-growth theme this year – arguing that a straight play on the highest dividend-yielding stocks looks relatively expensive after last year, and that the highest yielders are running out of room to grow their dividends.

"In contrast, there are many stocks with solid growth outlooks and plenty of room to raise payout ratios," she said. "Despite this, dividend growth stocks are trading at the biggest discount to dividend yield stocks in at least 20 years."

Merrill developed a screen to find the U.S. stocks that have the best potential to increase their dividends.

Merrill's dividend-potential screen

The screen looked at S&P 500 companies with:

Low leverage – a net-debt to net-operating-profit-after-tax (NOPAT) ratio below that of their industry average;

Low dividend payout ratio – dividends per share, as a percentage of earnings per share, below the industry average;

A free-cash-flow-to-dividends ratio of greater than 1.0 (indicating a strong ability to cover dividend obligations);

Positive earnings growth for past year and this year.

In order to fine-tune the criteria and shorten the list a bit, we've included only companies whose payout ratio is at least 5 percentage points lower than their industry average.

What we found

Our list reveals 23 names that meet our tighter criteria. We've listed them alphabetically by ticker symbol.

Merrill's report also included a list of S&P 500 stocks with a strong track record for dividend growth – companies that have raised their dividends every year since 1980. Only one stock – Sherwin-Williams Co. – made that list as well as our modified dividend-potential screen.