How to get high yields from cheap, stable stocks

When it comes to investing, it pays to know what's currently hot so that you can go out and buy the opposite. The fact is that unloved, unfashionable value' stocks often outperform headline-grabbing growth' stocks.

For example, a 1998 study by Professors Eugene Fama and Kenneth French noted that, between 1975 and 1995, value stocks (defined as those with a low price-to-book-value ratio) beat growth stocks across 12 of the 13 markets they tracked by an average of more than 7.5% a year. Using "high price-to-earnings ratios versus low price-to-earnings ratios would have had the same result", notes Tim Price in his Price Report newsletter.

Sure, there are periods when the reverse is true. In the late 1990s dotcom bubble, for example, stocks with seemingly no value at all (whether defined as profit, cash flow, or even tangible sales) beat everything else. But the effect rarely lasts long. Investors eventually come to their senses. The fallout for anyone left holding the most bubbly growth stocks at that point is dire. So what's the best way to build a value portfolio? There are "three critical statistics" to look at, says Price.

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The p/e and the yield

Firstly, there's the price/earnings ratio (the share price divided by earnings per share, or p/e). You can learn about p/e here, but in short, a low p/e relative to the sector suggests a stock is cheap.

Secondly, take the dividend yield (the forecast annual dividend as a percentage of the current share price). Dividends matter a lot. Around half of your total return from owning S&P 500 stocks since the mid-1920s would have come from dividends. Over the last decade, dividends would account for pretty much all of your return from FTSE 100 shares.

The trouble is, a high yield isn't always good news. For example, music retailer HMV was yielding 15% a while back, but this was a sign that its dividend was unsustainable, not that it was a bargain. Equally, says Price, some sectors can make the blood run cold no matter how much income they offer. He doesn't like property stocks, given "a poor domestic outlook", and we'd have to agree.

So a robust value screen might start with dividend yields and p/e ratios, but you need some back-up statistics to add to the screening process.

The Z-score

The point about value stocks is that you can't just look for cheap stocks. Sometimes stocks are cheap for a reason: they may be about to go bust, for example. So how do you test the mettle of a cheap-looking stock?

One way is to calculate its Z-score. This measure was devised by Professor Edward Altman as a way of screening stocks (non-financial stocks only, it should be noted) for bankruptcy risk. It's not perfect, but in a study it was shown to work about 70% of the time, so it does offer some solid reassurance about financial strength. A high Z-score (three or above) indicates a low risk of financial failure. But how does it work?

The Z-score is built on five key ratios that are weighted before being combined into a single number. The five are:

earnings to total assets (a measure of return on capital);

sales to total assets (a measure of the efficiency with which assets generate revenue);

working capital to total assets (another efficiency measure but this time in terms of the amount of cash tied up unproductively in stock and receivables);

the market value of equity to total liabilities (to check how concerned the stockmarket is about the level of debt being carried);

retained earnings to total assets (to gauge the size of a firm's earnings buffer in part because retained earnings can be used to pay dividends).

The one drawback of the Altman Z-score is that the data on individual firms isn't readily available as pre-baked Z scores for free. At sites such as Creditguru.com, you can feed in eight key pieces of data from the accounts and a calculator will generate the relevant Z-score for you.

So what are the pieces of data, and where do you find them? You can find earnings before interest and tax (also known as operating profit) and sales (turnover) on the profit and loss account. Then, from the balance sheet, you need to find total assets, total liabilities (short and long-term combined), current assets, current liabilities, and from the shareholders' funds part, retained earnings. The final number needed is the market value of a firm's equity, or market cap this is just the number of shares in issue multiplied by the share price.

In short, you're looking for a high yield, a low p/e and a decent Z-score. Translated, that means you're getting a decent income (the yield) from a cheap stock (the p/e) that's not about to go bust (the Z-score).

What to buy

Three stocks that cut the mustard are food retailer Sainsbury's (LSE: SBRY) yield 5%, p/e 11.5 and Z-score 3.09; household goods firm Reckitt Benckiser (LSE: RB) yield 3.5%, p/e 14.4 and Z-score 7.21; and utilities group Centrica (LSE: CNA) yield 4.8%, p/e 12, Z-score 3.1.

This article was originally published in MoneyWeek magazine issue number 547 on 22 July 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.