8 dividend stocks for a dull market

As the market rally slows, take a look at stocks that will keep paying even when their prices aren't rising. Here's a screen to help you find them.

With the rally in tech and other growth stocks losing steam, consider dividend-paying stocks to get you through the lull.

Because dividend stocks make regular cash payments to shareholders, you can score a worthwhile return even if the overall market goes nowhere.

When the market regains strength, your dividend stocks will likely move up as well. Thus you'll enjoy share price gains plus the steady dividend income.

I'm going to describe a stock screen for finding relatively low-risk dividend payers. Before I get into the details, you need to know how dividend-yield math works.

How yields add up

Dividend yield is analogous to the interest you receive on a bank savings account or certificate of deposit. It's the next 12 months' dividends divided by the price you pay for each share. For instance, the yield would be 10% if you paid $50 per share for a stock expected to pay dividends totaling $5 over the next year.

The dividend yield changes inversely to the share price. So, if the share price for the same stock moved up to $55, the yield to new investors would drop to 9.1%. (That's $5 in expected dividends divided by $55.)

Here's the flaw with the bank interest analogy: Unlike the interest you lock in on a bank CD, you can't lock in a dividend yield. There's no guarantee that a company won't cut its dividend payout while you hold the stock or that the stock won't drop in value. That makes dividend stocks riskier than federally insured bank CDs.

To compensate for the extra risk, my screen looks for stocks paying a minimum 3.75% yield, more or less double what you're likely to get from a bank these days. To minimize risk, the screen pinpoints relatively safe, low-debt, profitable companies. These are not out-of-favor value plays either. Passing stocks must be in favor with most market players, which, in my experience, makes them safer than out-of-favor stocks.

Here are the details.

Dividend yield

We'll start by limiting the field to stocks with expected yields of at least 3.75% and ruling out the riskiest dividend stocks: small companies and those paying abnormally high dividend yields.

Try raising your minimum to 4% if you want to limit your list to higher-yielding stocks.

Screening parameter: Current Dividend Yield >= 3.75

Yield too good to be true?

Because yields go up when share prices drop, many stocks with beaten-down share prices appear to be paying double-digit yields. Unfortunately, those abnormally high yields suggest that many market players expect a dividend cut. Whether those fears come to pass or not, double-digit yields signal high risk, which is what we're trying to avoid.

What's too high? Usually, yields of 8% and above would be enough to trigger a red flag. But because many stocks are still trading below normal levels, I allow stocks paying dividend yields up to 10%. Try reducing your maximum yield to 7% if you want to cut your risk or raising it to 15% if you want to throw caution to the winds.

Screening parameter: Current Dividend Yield <= 10

Avoid small caps
All else equal, large companies are safer bets than smaller companies. Bigger companies have the product diversity, experience and financial wherewithal to survive a tough economy. Market capitalization, which is the current value of all outstanding shares, is the best way to measure company size. To me, market caps below $2 billion define small caps, companies with market caps above $8 billion are large caps, and those in between are midcaps.

I rule out small-cap stocks by requiring a minimum $2 billion market cap. Try cutting that limit to $1 billion if you want to see more stocks.

Screening parameter: Market Capitalization >= 2,000,000,000

Next, we'll limit the field to fundamentally sound stocks that are highly profitable and carry relatively low debt.

Highly profitable

We'll measure profitability two ways: by checking the return on equity profitability ratio and by comparing a company's pretax profit margin to its industry.

Return on equity (net income divided by shareholder equity) measures how efficiently a company uses its assets to generate earnings. Many professional money managers avoid stocks with ROEs below 15%. But because this year has been a dud, I'm taking a longer view and require an average 15% over the past five years. Try reducing that figure to 12% if you want to see more stocks or raising it to 20% if you want to focus on only the most profitable companies.

Screening parameter: ROE: 5-Year Avg. >= 15

Profit margins
Profit margins measure the income earned per dollar of sales. For example, a 20% net profit means that a company earned 20 cents for each dollar of sales. In any given industry, the company with the highest margins takes home the most cash to develop products, increase dividends and do other good things.

Because companies may be paying different income tax rates, it's best to compare pretax profit margins. I require pretax margins at least 25% higher than the industry average.

Screening parameter: Pre-Tax Margin >= 1.25*Industry Average Net Profit Margin

Low debt
Given the uncertain credit markets, companies carrying little or no debt are safer than those with high debt. That said, requiring no debt would rule out most dividend-paying stocks. Also, the definition of low and high debt levels varies with the industry. Consequently, I allow moderate debt but limit the field to the lowest-debt stocks in each industry.

The debt-to-equity ratio, which compares debt with shareholder equity (a company's total assets minus liabilities), is a popular debt measure. A zero ratio indicates no debt, and the higher the ratio, the higher the debt. I set my maximum debt-to-equity ratio at 0.5, which equates to moderate debt.

Screening parameter: Debt to Equity Ratio <= 0.5 To confine the list to the lowest-debt stocks in each industry, I require debt-to-equity ratios no higher than 75% of the industry average. Screening parameter: Debt to Equity Ratio <= 0.75*Industry Average Debt to Equity Ratio Finally, we'll check institutional ownership, analysts' "buy" and "sell" ratings and each stock's own price action to confine our list to in-favor stocks. Check the smart money
Because they generate huge trading commissions, institutional buyers such as mutual funds are privy to better stock-moving information than individual investors. If they don't own a stock, you shouldn't either.

Institutional ownership, the percentage of a firm's shares held by these big players, ranges from 40% to 95% and sometimes even higher for in-favor stocks. I specify a minimum 40% institutional ownership.

Screening parameter: % Institutional Ownership >= 40
Analysts set market tone
Stock analysts advise whether to buy, sell or hold stocks that they follow. MSN Money compiles the ratings for each stock into these categories: "strong buy," "buy," "hold," "moderate sell" and "strong sell." Right or wrong, analyst ratings influence many investors. Thus any version of "sell" says the stock is out of favor.

Screening parameter: Mean Recommendation >= Hold
Stock price action
Relative strength measures a stock's return compared with the overall market. For example, relative strength of 90% means a stock has outperformed 90% of all stocks. Almost by definition, a stock must be outperforming the market to qualify as in favor.

I require a minimum 55% 12-month relative strength, which means that passing stocks must have outperformed a majority of stocks over the past 12 months.

Screening parameter: 12-Month Relative Strength >= 55
8 names worth a look
My screen turned up eight stocks when I ran it last week, all solid companies and major players in their industries. Click here to see which stocks the screen turns up today.