Cheap stocks are suddenly abundant. The S&P Composite 1500 index of large, midsize and small U.S. companies has lost 12% in three months. More than 300 of its members now have price-to-earnings ratios in single digits, suggesting a discount of more than one-quarter to historical levels.

That alone doesn’t make these stocks bargains. If earnings in coming quarters prove much lower than expected, today’s P/E ratios will have misled. The task for investors is to figure out which companies are both modestly priced relative to forecasts and likely to meet or exceed those forecasts.

One tool professional investors use to predict that is past earnings volatility. Companies with relatively smooth earnings histories — a low standard deviation of quarterly earnings, in statistical parlance — are more likely than others to deliver the same in coming quarters.

But this tool is of limited use now, because the past five years have produced chaotic results for much of the market, and traditionally stable industries now face challenges. Food makers must deal with crop inflation, soap and toothpaste firms are battling a shift in shopper preference to discount brands and even some utilities are seeing a drop in electricity usage. Some companies in these industries will report stable earnings over the next year, but perhaps not all of them.

So here are two ways to tell which firms are reliable. The first is to look for a recent dividend increase. That puts more cash in shareholder pockets, but just as important, it signals that managers are confident about future results. After all, no company wants to raise its dividend only to find the new payments unaffordable in the coming year.

The second is another statistical clue: a tight clustering of the earnings estimates issued by different analysts. Three decades of research, including recent studies by Anna Scherbina, now at U. C. Davis, show two important things about estimate dispersion. First, tightly grouped estimates are more likely than scattered ones to precede an upside earnings surprise. Second, stocks with clustered earnings estimates tend to outperform those without.

One theory on why this is so has to do with the earnings guidance that companies provide to analysts. Firms with good news to report tend to be more forthcoming with details than firms that are struggling, the thinking goes.

The 10 stocks below have modest P-E ratios and healthy dividend yields. They’ve also raised payments over the past year and have earnings estimates that show relatively close agreement among analysts.

Company	Ticker	Industry	Dividend Yield (%)	Forward P/E*	EPS Consensus, Next Quarter	High/Low EPS Estimate, Next Quarter
Abbott Laboratories	ABT	Drugs	3.8	11	1.44	1.49 / 1.39
Altria Group	MO	Tobacco	6.4	13	0.5	0.52 / 0.48
Analog Devices	ADI	Semiconductors	3.1	12	0.62	0.66 / 0.58
Campbell Soup	CPB	Food	3.8	13	0.66	0.71 / 0.62
Darden Restaurants	DRI	Restaurants	3.9	12	0.55	0.64 / 0.52
General Dynamics	GD	Aerospace & Defense	3.4	8	2	2.09 / 1.88
Johnson & Johnson	JNJ	Drugs	3.7	12	1.13	1.21 / 1.02
Mattel	MAT	Toys	3.5	12	1.02	1.10 / 0.94
Microsoft	MSFT	Software	3.2	9	0.84	0.88 / 0.77
Raytheon	RTN	Aerospace & Defense	4.4	8	1.39	1.48 / 1.34

By Charles Sizemore

Standard & Poor’s dropped a bomb on Europe on Monday, downgrading the European Financial Stability Facility (EFSF). Also known as the “bailout fund,” the EFSF was put in place to make emergency loans to Europe’s troubled sovereign borrowers.

The downgrade, though newsworthy, came as little surprise. After Standard & Poor’s downgraded France and Austria late last week, it was all but inevitable. If the guarantors of the bailout fund are no longer rated AAA, it’s hard to see how the fund itself could be. Germany is now the only major European country to be rated AAA by all major bond ratings agencies, and given that the burden for saving the entire Eurozone now rests on Germany’s shoulders, it’s debatable whether even mighty Deutschland deserves such a rating.

For investors, what does all of this mean?

Frankly, not all that much. The markets were mildly roiled by the downgrade of France, but the downgrade of the EFSF barely made a ripple. To investors battle-scarred by a volatile year of sovereign debt crisis, a ratings downgrade isn’t as scary as it used to be.

It seems like an eternity ago, but it was just this past August when Standard & Poor’s downgraded the United States. It set off a firestorm of volatility, but once the dust settled investors realized that very little had changed. The sun still rose in the east the next morning, and the bond markets continued to function as if nothing had happened. Contrary to investment orthodoxy, yields actually fell after the U.S. downgrade.

In the case of Europe, the reaction was muted. France had a successful bond auction on Monday, and Europe’s leaders met the announcement with a collective shrug.

This is not to say that all is well in the world. It’s more a case of resigned acceptance. As Matthew Broderick succinctly put it in The Freshman, “There’s a kind of freedom in being completely screwed because you know things can’t get any worse.”

This is more or less the market expectation for Europe today. The market has stopped reacting to bad news because more than enough bad news is already factored into prices. Ratings agencies have a well-deserved reputation for closing the barn door after the horse has already bolted. Standard & Poor’s told bond investors what they already knew—that debt-laden Europe is suffering from a crisis of confidence.

If you believe, as I do, that market confidence in Europe has reached its low point (or, at the very least, that it is close to doing so), then it makes sense to start accumulating shares of high-quality European blue-chip multinationals. I’ve been wildly bullish on the prospects for German stocks in recent months (see “Buy Germany While It’s Down“) but France has its share of attractive companies as well. Investors may want to consider picking up shares of French oil major Total S.A. (TOT) on any weakness. Total trades for just 7 times earnings and yields and impressive 5 percent in dividends.

Investors seeking yield may be particularly interested in French telecom giant France Telecom S.A. (FTE). France Telecom trades for 10 times earnings and yields over 9 percent in dividends. In addition to its dominant position in France, France Telecom also has great exposure to Africa and other fast-growing emerging markets.

If you prefer a one-stop-shop for French stocks, the iShares MSCI France ETF (EWQ) would be a good bet. In addition to Total and France Telecom, EWQ counts luxury powerhouse Moet Hennessey Louis Vuitton and pharmaceutical giant Sanofi among its largest holdings.

With interest rates hovering near all-time lows, investors needing income are faced with very limited choices. The traditional high yield available from bonds and other fixed income vehicles are no longer available to meet the needs of retirees needing income to live off. Moreover, it is almost a certainty that today’s low yields are not adequate enough to fight inflation. Consequently, there is a growing investor interest in dividend-paying common stocks, especially those that have a long record of increasing their dividend every year. This has led many lay, and even many professional investors, to assume that dividend-paying common stocks are becoming overvalued. In addition to being too general to be relevant, these assumptions do not stand up to closer scrutiny.

Our research indicates this to be a fallacy, because in truth we have discovered numerous dividend-paying enterprises that are trading at historically low valuations. But even more importantly, in addition to being historically low, we have identified numerous blue-chip companies that are trading below their intrinsic values based on fundamentals, primarily earnings and cash flows. Today’s growing interest has yet to compensate for the enormous aversion to equities that most investors have after being traumatized by the great recession of 2008 and the precipitous drop in stock prices that accompanied it.

On the other hand, not all dividend-paying common stocks are the same. Therefore, we believe that potential investors need to be very discerning regarding the type and quality of the dividend paying stocks they are willing to invest in. This is especially true for those investors seeking to either augment or replace their fixed income investments with common stocks. Since the major attractions and benefits of fixed income in addition to yield, are safety and low risk, it only makes logical sense that a dividend-paying strategy being considered to replace or supplant it should focus heavily on the same issues.

Dividend paying common stocks come in many different flavors and range from very aggressive to very conservative. When considering alternatives to fixed income because of today’s low yields, we would argue that the emphasis should be on the most conservative dividend paying common stocks possible. In this vein, the reliability and predictability of a given dividend payment should rank high in importance. With that said, a logical place to begin looking is at companies that have long histories of paying dividends, and even better, a long history of increasing them each year. Although there is no guarantee that this will continue, a long track record certainly instills confidence.

One of the best sources available for identifying companies with long histories of dividend excellence is with David Fish’s CCC lists of Dividend Champions, Contenders and Challengers. The Champions list is comprised of companies that have increased their dividend every year for at least 25 consecutive years, the Contenders list is comprised of companies that have raised their dividends for 10 to 24 years, and finally, the Challengers list is comprised of companies that have increased their dividends every year for between five to nine consecutive years.

It’s important to point out here that in theory at least, the Champions list is a more conservative group than the Contenders list which in turn is more conservative than the Challengers list. As a general statement, we believe this is true, but like most statements that are too general, the devil is in the details. Consequently, even though the Champions list is in theory the most conservative, we believe that there are names on the Contenders list that are even better quality, and therefore, more conservative than some of the names on the Champions list, and vice versa. Our last article dealt with the Dividend Champions that we believe are on sale. This is important because low prices and valuations are great attributes that mitigate risk in their own right. This article will look at 42 Dividend Contenders that we believe are reasonably priced, too in some cases, significantly undervalued.

42 Dividend Contenders on Sale

This list of Dividend Contenders, like the list of Dividend Champions before, is offered as a prescreened resource made available prior to engaging in a more comprehensive analysis. However, there is a difference between these lists and the traditional lists that are sorted by mere numbers or statistics. Currently, there are only 102 Dividend Champions and only 146 Dividend Contenders. Therefore, we were able to quickly and easily evaluate each company on the lists by running a F.A.S.T. Graphs™ on each company that provides essential fundamentals at a glance. Therefore, we feel that this screen is more comprehensive than one based simply on statistical analysis.

Instead of bothering you with a long iteration using words and numbers to articulate what we screened for, we let a few pictures tell a few thousand words instead. The premium version of F.A.S.T. Graphs™ has David Fish’s lists pre-loaded, with his permission of course. Therefore, it was a simple matter of scrolling through each company to determine whether or not it met our criteria of fair value, and whether or not it possessed the quality characteristics of predictability, reliability and consistency that we could be comfortable with. With our first run through, we took price out of the equation so as to only reveal the essential fundamentals of earnings and dividends on each company at a glance. Then we ran through the exercise again, only this time we added monthly closing stock prices to the graphs.

Remembering that we are coveting consistency and predictability with compiling our list of Dividend Contenders on sale, let’s review two graphs showing earnings (orange line with white triangles) and dividends (blue shaded area paid out of but stacked on top of earnings) exclusive of stock price.

Two Contenders Rejected because of a Lack of Consistency

Alterra Capital Holdings Ltd. (ALTE)

Our first example, Alterra Capital Holdings Ltd. (ALTE) is a Bermuda-based holding company created by the merger between Max Capital Group and Harbour Point Limited in May of 2010. Max was a holding company formed in 1999 that went public in May of 2001 and paid a dividend that increased every year since (see DIV listed at the bottom of the graph). Although this 11-year record of increasing dividends qualifies it as a Dividend Contender, it was excluded due to the enormous cyclicality and unpredictability of its earnings (see red box at bottom). Simply stated, we didn’t feel it was conservative enough to be considered as a potential fixed income replacement.

RenaissanceRe Holdings Ltd. (RNR)

Our second example, RenaissanceRe Holdings Ltd. (RNR) is a property catastrophic reinsurance company that has increased its dividend every year for 19 consecutive years (see DIV at bottom of the graph). Once again, the severe cyclicality and unpredictability of their earnings growth caused them to be excluded from our conservative list, even though their record of dividend increases has been long. This decision was made instantly by simply reviewing their earnings record (orange line).

In addition to highly cyclical names like the two examples above, we also excluded MLPs and REITs, as we consider these typically high-yield vehicles too risky to be considered as fixed income substitutes. However, there are many who would disagree with that position on these asset classes.

Two Quintessential Examples of What We Were Looking For

Stryker Corp. (SYK)

Stryker Corp. (SYK) has raised their dividend for 19 consecutive years in conjunction with an impeccable record of consistently increasing their earnings at the above-average rate of 18.4%. With very little debt on the balance sheet, this company represents the quintessential example of the type of predictable high-quality business we were seeking.

International Business Machines Corp. (IBM)

Affectionately known as Big Blue, IBM is arguably one of the bluest of all blue-chip technology stocks. The record of consistently increasing earnings at the above-average rate of 11% per annum since 1998 coincides with increasing their dividend for 16 consecutive years. Once again, IBM represents the classic earnings pattern and fundamental qualities that we were seeking.

Bringing It All Together

Some Contenders Are Fairly Valued

With our United Technologies Corp. (UTX) example below we put it all together by adding monthly closing stock prices (black line) to the earnings and dividend graphs. In order to make our list of Dividend Contenders on sale, the company’s stock price had to sit at or below its intrinsic value (the orange line) as United Technologies Corp.’s price clearly does.

In addition to just pure dividend income, this article is further focused on total return. Since, under normal circumstances, there is more risk owning equities than owning fixed income, it is important that our candidates offered the opportunity for an attractive total return to compensate for the risk. One of the most overlooked elements of risk is valuation (overvaluation). Even though United Technologies (UTX) is currently moderately undervalued based on our calculation of intrinsic value (the orange line), it nevertheless generated a very attractive long-term total return for shareholders because valuation was sound at the beginning of 1998, and therefore, valuation risk was reasonable.

Some Contenders Are Extremely Undervalued

Teva Pharmaceutical Industries (TEVA)

Teva Pharmaceutical Industries (TEVA), a leading global generic and branded pharmaceutical company headquartered in Israel represents a compelling valuation at today’s levels, in our opinion. Teva has grown earnings very consistently at a compounded rate exceeding 23% per annum, which we believe warrants a much higher PE ratio than the meager P/E of 9 that the market is valuing its shares at today.

With the consensus five-year earnings estimates ranging from the low of 9.6% from 20 analysts reporting to Capital IQ to as high as 17.5% by 17 analysts reporting to Zacks, we believe the minimum P/E of 15 to as much as a P/E of 20 is warranted for this high-quality pharmaceutical with only 16% debt on its balance sheet. Consequently, we see a high probability for outsized future returns based on low valuation and long-term growth potential.

Harris Corp. (HRS)

Harris Corp. (HRS) is a leading international communications and information technology company. Note that although earnings were a little inconsistent from 1998 into 2003, since that time they have consistently advanced. Harris Corp. can currently be bought at what we believe to be a ludicrous price earnings ratio of only 7.4. We believe a more appropriate price earnings ratio for this dividend contender that has raised its dividend every year for 10 consecutive years, and now offers a starting yield of 3%, should be awarded at least a 15 PE. This implies an intrinsic value that is more than double from where the company’s price currently rests. This is why Harris Corp. (HRS) sits at number two on the list for the highest five-year estimated total return.

Close Calls – Quality Rejected Because of Modest Overvaluation

There were several names that were rejected due to modest overvaluation. A few examples include T.J. Maxx (TJX), Ross Stores (ROST), Federal Express (FDX), Nike (NKE), T. Rowe Price (TROW), Casey’s Gen. Stores (CASY) and others. The following earnings and price correlated graph on Church & Dwight Inc. (CHD) represents overvaluation because stock price is higher than the orange earnings justified valuation line. We believe that each of these names listed in this paragraph are strong potential candidates if their stock prices came back into sound valuation levels. For example, we would consider Church & Dwight (CHD) a buy in the mid-$30 price range.

Obvious Overvaluation Rejected

The following two examples, Royal Gold Inc. (RGLD) and Fastenal (FAST) represent extreme and obvious overvaluation (orange line represents fair value). Although both of these names appear to be excellent businesses, the valuation risk of investing in these dividend contenders is heightened by an earnings yield that makes no economic sense; therefore, they were easily and summarily deleted from the master list because of extreme overvaluation.

42 Contenders That Made the Cut

After rejecting Dividend Contenders that revealed themselves as either being too risky, too inconsistent or too expensive, we ended up with the following 42 companies that have increased their dividend every year for a minimum of 10 to 24 consecutive years. Consequently, we offer them as a fertile source of potential candidates for both investors seeking an above-average and growing dividend yield, as well as investors looking for above-average total return at reasonable levels of risk.

In other words, we believe this list offers opportunities for further exploration for all dividend income oriented investors. Dividend yields range from as low as .8% to as high as 5.2%, with almost everything in between. Also, keep in mind that each of these selections has been screened for fair value or preferably undervaluation, and each has increased their dividend every year for at least 10 consecutive years.

A few words on the column headings are offered for clarification purposes. First, we compare each company’s current PE ratio to its historical normal 15-year P/E ratio. However, note that the five-year estimated total return is not based on each respective company returning to its normal PE ratio. Instead, the five-year estimated annual total return is a calculation based on the consensus estimated EPS growth (five-year) and then applying an appropriate P/E ratio to that growth. Historical EPS growth plus expected EPS growth are also side-by-side in order to provide a perspective of whether EPS growth will be higher or lower in the future than it was in the past. Market cap, the company’s level of debt and the sector it operates in round off the table, with our candidates listed in order of highest estimated total return to lowest.

Conclusions

There are several reasons why we are offering these articles on dividend-paying growth and income stocks, first and foremost is to illustrate that there are numerous extremely high-quality dividend paying stocks that are available for purchase today at very attractive levels. The opportunity to invest in extremely high-quality stocks at historically low valuations that offer both a growing dividend and capital appreciation is rare. Unfortunately, many investors remain traumatized and are currently eschewing quality dividend-paying common stocks in favor of fixed income, at precisely the time when they should be looking at quality equities with a strong dividend record. Don’t forget, each of the companies on this list raised their dividend right through the great recession.

Even though we have always embraced fixed income as a viable asset class that can, during normal economic times, appropriately be capable of meeting certain goals and objectives of many investors inclined towards safety and the highest yield possible, we are currently, and we believe temporarily, altering our stance. We believe that today’s artificially induced and extremely low interest rate levels represent uncommon dangers with owning fixed income instruments. Therefore, we believe that carefully chosen extremely high-quality dividend paying common stocks represent a viable alternative for safety conscious investors under today’s economic conditions. Yes, there may be more risk, but a potentially higher total rate of return and increasing dividend income stream compensate for this greater risk, in our opinion.

Finally, this article in particular is offered to illustrate that there are vast differences in the types and quality of various classes of dividend paying common stocks. We feel that there’s been way too much generalization with too little focus on the specifics that encompass the many differences and attributes that various kinds of dividend paying stocks possess. There are quality dividend paying stocks, there are risky dividend paying stocks and there are very expensive dividend paying stocks and in some cases there are very inexpensive dividend paying stocks, etc. To us, to investing is about making these distinctions one at a time, while avoiding the natural but erroneous temptation to over-generalize. In this vein, this article only scratches the surface of what could be discussed and evaluated regarding the desirability of investing in dividend paying stocks.

Disclosure: Long SYK, TEVA, UTX, AVP, CVX, MDP and UTX at the time of writing.