5 simple rules to find good dividend stocks

This week I’m going back to basics. I’m going to try and create a screen that uses the simplest rules possible to help me find good dividend shares.

I’ll then give some suggestions on how I might use the results to start building an income portfolio.

The screening metrics I’ll use will be simple and widely used. I will also use as few rules as I think possible, instead leveraging the power of Stockopedia’s excellent data set and the StockRanks to help me find suitable shares.

This approach is intended to be of interest to newer investors, but I think it should also be useful for more experienced investors as well, as it provides plenty of ideas for further in-depth research.

Why go back to basics?

I’ve written a lot about screening over the years. I think screens are a great way to help narrow down our investment universe and find shares with the characteristics we want. But this approach isn’t without risks.

One of these is over-complication. Many top investors have warned of the dangers of complexity, including Warren Buffett:

The business schools reward difficult complex behaviour more than simple behaviour, but simple behaviour is more effective.

When building a screen, it’s tempting to use many exotic and precise metrics to try and find companies with particular qualities.

Doing this may produce a gratifyingly small set of results. This makes it easy to believe you’ve discovered the holy grail of investing strategies and have identified precisely the best shares to buy today.

Unfortunately, this is unlikely to be true, at least in my experience. As Ed has explained previously, the perfect stock doesn’t exist. A portfolio of 10-20 stocks with slightly different characteristics is usually a more fruitful approach to investing.

Another risk with overly precise screening is that you may end up subconsciously reverse-engineering your rules so that they select shares you are already attracted to.

With these caveats out of the way, let me explain how I’ve approached this screen.

Building the screen

I’m looking for well-established companies, with a decent record of dividend payments, a reasonable yield and no obvious signs of excessive debt.

I also want good liquidity – and to avoid anything that might be a special situation or which might require in-depth research.

Here are the rules I’ve used to try and narrow down my search. In this example I’ve applied my screen to the UK market, but I think it should also be suitable for other developed markets with high standards of corporate governance, such as the US, EU, and Australia.

Market capitalisation > £1,000m: I’ve focused my search on mid-caps and large caps. There are some good dividend shares among UK small caps, but I think some of them require more individual judgement and research than these larger companies.

Dividend yield > 3%: with interest rates over 5%, I don’t think yields under 3% are very appealing from an income perspective, even if the payout is growing fast.

Dividend per share 5yr CAGR > 0%: the impact of pandemic dividend cuts is still rippling through the accounts at many decent firms, so I’ve kept this rule quite loose. But I want companies with a proven history of maintaining their dividends, so I’m not interested in companies whose payout is still lower than it was five years ago.

Net debt to Equity < 50%: keeping debt liabilities to less than half a company’s book value should reduce the chance of financial distress, in my view.

However, I think it’s always worth taking a look directly at the balance sheet and cash flow statements, too. One simple ratio does not always tell the full story.

StockRank > 50: shares with higher StockRanks have outperformed those with lower StockRanks over the last decade, in aggregate.

I think it makes sense to focus my efforts on shares with higher StockRanks.

Here’s how the finished screen looks:

You can see (and copy) my simple dividend stocks screen here.

Screen results

At the time of writing, this screen returns 32 stocks. For me, that’s a nice number to use as a starting point for further research.

Here are the results:

Building an income portfolio

These results are not a list of stocks to buy. Some further research is needed. There are also a number of sector duplicates in the list above. For example, housebuilders and packaging companies.

Portfolio construction: To start building a simple dividend portfolio from this screen, I would probably aim to add five shares every two or three months, aiming for a portfolio of 20 stocks.

The results of the screen will vary over time, so staging the purchases in this way may provide a more diverse range of opportunities, rather than relying on a snapshot at one moment.

Selecting stocks: to select stocks, I’d probably start by adding an additional sector rule. I’d then use this as a filter, selecting different sectors to look at the results from each one. As a rule of thumb, I would probably aim to buy between one and three stocks from each sector, depending on market conditions and my preferences.

For example, choosing the Consumer Cyclicals sector in the list above gives me the following choices:

Sorting the screen results by StockRank provides a useful extra level of filtering. It’s my default approach with most screens.

Looking at this list, I think there’s enough diversity here to justify two or three purchases, for someone who wants exposure to the consumer economy.

From the four housebuilders, I would probably choose Redrow (LON:RDW). I like its founder ownership and I think the business looks in good health, with a lot of bad news already priced in.

I might also consider Kingfisher (LON:KGF), which owns Screwfix and B&Q, among others. I think the shares look cyclically cheap at the moment and I don’t think it’s a bad company.

Elsewhere, Games Workshop (LON:GAW) and Burberry (LON:BRBY) provide exposure to quite different markets and both could be interesting, in my view.

Final thoughts

I have built portfolios using a similar process to this in the past and have been quite satisfied with the results.

Valuations in many sectors look quite reasonable to me at the moment, so I think that some decent choices are available – unless we are heading for a serious economic slump.

Personally, I would spend some time understanding each business and reviewing its recent performance before pulling the trigger. But I think that even with quite minimal research, using this approach in partnership with the StockRanks could deliver reasonable results.

Please let me know what you think in the comments below. Is this back-to-basics approach helpful, or do you think it’s too simplistic?

Disclosure: Roland owned shares in Burberry at the time of publication.