This article was originally published here in February 2003
I was recently speaking to a friend who felt that the recent sharp fall in the stock market might have been overdone. He wanted to invest in good, solid companies whose share price should strongly rise in any recovery. His problem was how to locate such companies.
We came to the conclusion that what we were looking for was high yielding but financially strong larger companies. To locate such shares I used the three share selection filters described below. I applied the filters to the largest 350 companies on the stock market. These companies form the FTSE-100 and the FTSE-250 indexes, known collectively as the FTSE-350. The companies range in size from BP worth £88 billion down to roughly £200 million for the smallest companies in the index. I feel that a large part of the decline in share prices is due to investment companies selling off their more liquid holdings. These larger companies will be the first to benefit from any revival of prices.
I do not put much faith in share analysts’ views but they can be useful at times. They produce forecasts of future company performance. I am interested in the dividend yield they forecast for each company. In the financial pages of the papers you may have seen some companies listed with mouth-watering double-digit dividend yields. Beware of such companies. The yield printed in newspapers is usually the historical yield; i.e. the dividends paid last year as a percentage of the current share price. If a company has announced a cut in its dividend payments the share price will decline, raising the historical dividend rate. By using the forecast dividend yield we avoid this problem.
As well as forecasting future dividend payments, share analysts also estimate the future level of company’s profits, or Earnings Per Share. Dividing the forecast future Earnings Per Share by the forecast Divided Per Share gives the future Divided Cover ratio. This is an important number for us to use in our hunt for secure companies. The higher the Dividend Cover, the greater the profits backing the dividend payment. A Divided Cover ratio less than one indicates that the company is paying out more in dividends than they are making in profits. They will be doing this in the hope that profits will soon recover. If they do not the divided will have to be cut, which usually leads to a sharp fall in the share price. Choosing companies with higher Dividend Cover ratios should help avoid this situation.
I calculate ratio by dividing a company’s net outstanding debt by its current market capitalisation. The lower the number, the more sound a financial condition the company is in. If the number is negative the company has more cash than debts. I chose to filter out all companies with a gearing ratio above 30%. Companies below this level are unlikely to run into cash-flow trouble and be unable to service their debts.
I applied these selection criteria to the companies in the FTSE-350 index. I looked for a forecast dividend yield of at least 4%, a forecast dividend cover of at least 1.5 times and a current gearing of no more than 30%. I ranked the 26 companies that survived the cut by multiplying the dividend yield by its cover. Here are the top 13:
Sector Price Yield Cover
Westbury Construction & building 252p 4.80% 5
Barratt Developments Construction & building 374p 4.20% 4.8
Taylor Woodrow Construction & building 161p 4.60% 4.1
Dixons Group General Retailers 104p 6.40% 2.8
BAE Systems Aerospace & defence 117p 8.10% 2.1
Countrywide Assured Speciality & other fin 112p 5.40% 3
W H Smith General Retailers 290p 6.90% 2.2
Inchcape Automobiles & Parts 667p 4.50% 3.3
First Choice Holidays Leisure, entertainment 82p 5.90% 2.3
Carillion Construction & building 116p 4.10% 3.2
Debenhams General Retailers 266p 5.20% 2.4
Weir Group Engineering & machinery 197p 6.10% 2
Lonmin Mining 769p 6.00% 2
It is interesting to see the top three companies are all house builders. I guess the market is already starting to discount such companies in the likelihood of a housing slump.
Of course, by the time that you read this, numbers in the table above will be wrong. Prices will have changed and some companies might have announced profit warnings or dividend cuts. Please do your own research before taking any decisions.