Dividends and The Little Book

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I recently read an article by Dividend Dog in which he touts the benefits of overlaying a dividend screen on the stock picking method explained by Joel Greenblatt in his book “The Little Book that Beats the Markets.” Essentially, the secret sauce is a system of annually picking stocks with high earnings yields and high returns on equity.

I don't question the system or its performance. In fact, I think it is an interesting screen for turning up good investment ideas, and Dividend Dog's idea of adding a dividend component makes Greenblatt's system particularly useful for income focused investors. However, I think that most dividend focused investors will find annual changes to their portfolios problematic.

A Good Start, But...
If you are investing for dividend income, you are, most likely, trying to live off of your dividends. An annually rebalanced portfolio won't provide a consistent income stream. Every year you will need to readjust your spending to a new level of dividend income. That's simply not a workable situation. In effect, you will be going through a lot of effort to create a portfolio meant to produce total return, using dividends as a secondary screen. What you won't be creating is a dividend income portfolio.

You Might Not Get What You Need
Moreover, by following a rote system, you will probably find yourself owning stocks that you would otherwise choose to avoid. One example that stuck out like a sore thumb was PDL BioPharma (NASDAQ: PDLI). PDL BioPharma has a patented process to create humanized antibodies. The company earns revenue by licensing its technology to produce humanized antibodies to other companies. While this has led to strong revenue growth, technology doesn't last forever. If you only planned on owning PDL for a year, maybe it would make sense to take on these risks. However, with a high level of debt on top of being a one-trick-pony, long-term investors are probably better off avoiding this company's impressive 7.9% dividend yield. This example aside, there are some potential gems on the list, too.

The Company Formerly Known as Computer Associates
Several years ago now CA (NASDAQ: CA) went through a highly publicized and fairly ugly scandal involving high ranking company employees. Today, it provides IT services across mainframes and other physical products and in the nebulous worlds of virtual and cloud computing. CA's stated goal is to “help organizations accelerate, transform and secure [customers'] IT infrastructures to deliver flexible IT services.” It breaks its business into three groups: Mainframe Solutions, Enterprise Solutions, and Services.

In early 2012, the company upped its dividend from $0.20 per share annually to $1.00 per share annually. That's a huge jump, leaving it with a high, but manageable, payout ratio. While CA definitely isn't in the same league as IBM (IBM), it is a large player with a solid market position that seems poised for slow-to-modest growth over the foreseeable future. With a 4.5% yield, dividend investors looking for technology exposure shouldn't be afraid to take a look here.

Defense On Sale
Lockheed Martin (NYSE: LMT) is another interesting highlight from the list, given the spending cuts that are slated to take place in the U.S. defense budget. The uncertainty about the defense budget has taken a notable toll on this company's shares. The so-called sequestration cuts that have been written into law are likely to be painful for the industry if enacted. However, most agree that the draconian cuts are not likely to take place, with Obama himself hinting as much during the presidential debates and recent concessions between the Democrats and Republicans hinting at a potential solution.

Even if the cuts do take place, it is still unclear how they will impact industry participants. With its massive scale and reach, Lockheed Martin will definitely feel the pinch of any cuts, but it is also very likely to survive any cuts that do take place. That could make now a good time to buy the stock, as it is yielding around 5%. This is particularly true since the company is probably one of the best positioned defense companies around when looking out over the long term. Indeed, its fingers extend into virtually every aspect of the industry from space exploration to military services, including expanding operations in the technology space. The best part is that Lockheed's dividend has historically been increased on an annual basis.

Wintel
Microsoft (NASDAQ: MSFT) and Intel (NASDAQ: INTC) also made the list. For years these two companies have formed the core of most personal computers. Each is a giant in its own right.

Microsoft is best known for its Windows, Office, and Xbox franchises. These are big businesses that appear to have years of dominance left despite technology changes that have given competitors Apple (AAPL) and Google (GOOG) solid positions in newer, faster growing markets like the Internet and mobile computing.

Microsoft, however, is financially strong and its businesses are so big, that it can can afford to step into other areas and struggle until it finds success. For example, the Xbox wasn't an instant success and required years of investment before Microsoft saw a dime of earnings. Now it is one of the major players in the video game space.

The company's most recent foray is in operating systems for smart phones, an area that is dominated by Apple and Google. Microsoft has formed an alliance with cell phone maker Nokia (NOK) that has produced some highly regarded phones. If these phones lead to a broader adoption of Microsoft's cell phone operating system, the company will have gained an important foothold in this new market. If not, it has plenty of time and resources to try again. With a 3.5% yield, Microsoft is an interesting choice for investors seeking technology exposure and income from a still dominant industry player.

The other half of Wintel is Intel. This tech giant has been having a difficult time keeping pace with the industry's shift to mobile devices, a segment in which it doesn't get much respect. This is with good reason, though, since rival chip makers appear to have better industry positions. This has led to a material slide in Intel's shares, and left it yielding around 4.5% of late.

This could be a solid entry point for income investors with a value bias, since, like Microsoft, the company has plenty of cash and clout to take on its current challenges. Indeed, it could use its own research and development might to further penetrate the cell phone space or simply acquire its way in to more market share. Note, too, that the whole mobile computing/cloud computing idea requires vast server farms that often run on Intel chips. So while it may appear that Intel is at a disadvantage in this emerging space, it has a few tricks up its sleeve that should keep the lights on and dividend flowing for years to come. Moreover, the company recently announced changes in the CEO post which have the potential to spur the company's efforts in the mobile space.

Both Intel and Microsoft have been increasing their dividends of late, making them both interesting for their current yields and dividend growth.

Screens Are A Good Start, But Not The End Point
For a dividend investor, Dividend Dog's list of Magic Formula dividend stocks is a great starting point for finding long-term investment ideas. The four stocks above prove that. However, following a system that rebalances every year will only complicate your income needs if you are trying to live off of your dividend income. I suggest you consider earnings yield and return on equity as part of your screening process, but you'll need to dig deeper to find the stocks that are long-term gems.

Yours,

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ReubenGBrewer has no positions in the stocks mentioned above. The Motley Fool owns shares of Intel, Lockheed Martin, and Microsoft. Motley Fool newsletter services recommend Intel and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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