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How to Find a Good Dividend Growth Stock - Part 1

Thought I'd try something different here on the Clear Eyes Investing blog. I was planning to add a few dividend growth stocks to my watchlist -- maybe even buy one or two if they're trading at a good price -- and figured I'd share my research process over the course of three blog posts.

• In today's post, I'll establish a research objective, screen for ideas, and put each of the ideas through a "five-minute sniff test" to determine whether or not they're worthy of further research. 
• In next week's post, I'll put the handful of remaining stocks through the Dividend Compass spreadsheet in order to learn a little more about the companies and the dividends' sustainability and growth potential. 
• In the final installment, I'll hopefully have two or three good ideas that have passed the initial tests. I'll do more detailed research on the select names, consider their valuations, and potentially invest in them. 

I hope this will be an interactive process. So please share your comments, questions, and criticisms along the way!

Step 1: Set an objective

Identify quality dividend-paying small- to mid-cap companies with sustainable competitive advantages and the potential for 7%+ annual dividend growth over the next 7-10 years.

Step 2: Screen for ideas

To focus my search on a few promising names, I used Yahoo! Finance's free screening tool and set up four parameters:

• Market cap: Between $500 million and $3 billion 
• Yield: Between 2% and 4%
• Return on assets: >= 5%
• Profit margin: >= 10%

I typically include a metric for financial leverage such as debt/equity, but depending on how many companies show up in the screen, I'd rather evaluate leverage manually. Also, for this exercise, I'm sticking with shares that trade on the U.S. markets, but the same process and principles should apply to other markets.

Here are the results (click to enlarge):

Yahoo! Finance

First, I need to double-check the screen result data to make sure its accurate. This is a good practice even with premium screeners, but errors are much more frequent with free screeners. Lo and behold, there are some inconsistencies with the dividend yields. Here are the corrected figures (click to enlarge):

*a triple-check revealed AWR's ttm yield is 2.6%...amazing how inconsistent data can be across providers

Right off the bat, then, we can eliminate a few names as their yields fall outside my desired range. Textainer Group and Giant Interactive have yields that are too high for an ideal dividend growth investment. Perhaps they're good value or even high yield investments, but from a dividend growth perspective, you have to wonder why they're trading with such high yields in a bullish market like we have today. You would think that if the companies had strong growth prospects that the stocks would be bid up to the point where the yields better approximated the Russell 2000 Index average yield of 1.4%.

I'm also going to eliminate Weight Watchers International, The Buckle, and Oxford Industries. Good companies perhaps, but their yields fall well below the 2% minimum. MTS Systems and Choice Hotels are right on the border, but we'll hang onto them for now.

With the list whittled down, let's put the remaining 12 names through the five-minute sniff test.

Step 3: The Five-Minute Sniff Test

With so many stocks to sort through in a typical screening exercise, it helps to have a "sniff test" process in order to make the most of your time.

A few things I check before moving forward with a dividend growth stock idea are:

• Has the company paid a dividend for at least five consecutive years without dividend cuts?
• Has the dividend been increased by at least 7% on average over the last five years? 
• Is the five-year average return on equity/capital over 12%?
• Has the company generated free cash flow in at least four of the past five years?
• Is the debt/equity below one?

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