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By Rupert Hargreaves

Dividends are a key part of most investors’ financial strategy. However, not all dividends are created equal, and chasing yield can often end in tears.

To help investors select the best income stocks, Société Générale publishes a monthly income screen, highlighting the best dividend stocks in developed markets based on a number of quality criteria. The bank also publishes a high dividend risk screen, which picks out those companies that are most likely to cut their dividends in the near future.

The December results of these two screens can be found here; hopefully, they will help you improve your investing process to some degree.

In addition to the two monthly dividend screens, SocGen also publishes a more comprehensive Global Income Investor report, which details the drawbacks, benefits and risks of income investing. Below are some of the key takeaways from the report, along with some top income picks.

Dividends: The biggest driver of equity returns

It’s no secret that dividends are the most significant driver of equity returns over the long-term. Dividend reinvestment is key to wealth creation and bypassing this step can severely impact your long-term returns.

For example, SocGen’s figures show that since 1970 US equities with dividends reinvested have produced an annualized real return of 5.2%. However, if dividend payments were spent instead of reinvested over the same period, the average investor’s real return would be 3% per annum. Excluding dividends entirely, equities have produced an annualized real price return of only 2.2% since 1970. The compounding effects of the dividends really do dominate returns in the long run.

Finding the best dividends for the long-term isn’t an exact science. A high dividend yield isn’t always the better dividend yield as SocGen’s data shows.

According to SocGen’s research, on average, the spread between the expected dividend yield (the payout analysts expect) of a particular stock, and the realized yield (the payout that investors actually receive) starts to widen above 4%. In other words, if a stock’s expected dividend yield is greater than 4%, the chance of the actual payout being less than the market expects, increases with every 100bps increase in yield, as the chart below illustrates.

SocGen’s evidence shows that high dividend yields should be avoided and that includes the constituents of the FTSE World High Yield index, which has consistently produced a realize yield below what has been expected. Many of the stocks in the index yield more than 4%.

Dividends: Look for quality

SocGen looks for four factors when trying to identify dividend cuts. The first two factors are both market-based specifically, a poor 12-month share price performance and high share price volatility. The second two factors are related to the company’s financial situation namely, reduced profitability (low ROE, ROA, and high accruals) and a weak balance sheet.

The three factors the bank believes do not help predict dividend cuts are:

Earnings or free cash flow cover

Three, five or ten-year dividend track record

Historical dividend growth

SocGen’s preferred methods of calculating a company’s balance sheet strength and quality, (as a result its dividend sustainability) are the Merton model (balance sheet strength) and Piotroski F-score.

The Merton model looks at the equity of a firm as being a call option on the firm’s assets. SocGen employs the model to determine a company’s ability to service its debt, meet its financial obligations and to gauge the overall possibility of credit default. Companies with the highest Merton model scores have produced the best returns for investors over the long-term with the least volatility.

Also, the evidence shows that the shares of companies with higher F-scores have outperformed those of lower quality peers.

A dividend screen

Based on all of the above, SocGen has put together an income screen for searching out the best income stocks in the world. To qualify for the screen companies must have a market cap greater than $3bn with Merton score in the top 40% of the universe, a Piotroski score of > 7 and a dividend yield of >= 4%. Companies no longer qualify if their Merton score declines, their Piotroski score falls below 3, and their yield falls to less than 3.5%.

Since 1989 this screen has produced some impressive results:

And the companies that currently qualify for SocGen’s income screen are shown below:

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