Like any other investment strategy, buying dividend-paying stocks requires discipline. That means locating correct buy and sell points by using both fundamental and technical analysis. But, before you get to that point, you have to decide what type of stocks you’re looking for and create a watch list of potential purchases.

In my practice, I focus only on blue-chip dividend-payers. By limiting my research to quality dividend stocks, I can narrow down my universe of potential purchases. However, there’s still a lot of work left to whittle the list down to only 20 to 40 stocks that I’d like to own. (I think owning 20 to 40 stocks gives sufficient diversification of dividend stocks in at least a handful of sectors to lessen risk.)

Here are the criteria I use to help narrow the field and find potential winners with a three- to five-year time horizon:

The Fundamentals

• Above-Average Credit Rating: I look for companies with a credit rating of B or better from Standard & Poor’s or Value Line. B-rated companies offer investors average financial stability, so if you’re particularly averse to risk, you may want to focus only on A-rated companies. You’ll have a more limited number of stocks to choose from, but you should still find some good ideas.
• High Relative Dividend Yield: A dividend yield that offers a higher yield than the market itself isn’t too hard to find because the market’s yield, as measured by the S&P 500, is only about 1.5% right now. Still, if I can find a stock that offers twice the market’s yield, I try to find something extra to like about it to warrant a purchase. A stock’s quarterly dividend is my best friend as it offers a cushion in a challenging market.
• Consistent Dividend Growth: I like to highlight companies that have a strong history of not only paying dividends, but also raising them on a consistent basis. A company that raises its dividend year after year sends a strong signal of financial and earnings stability – earnings have to exist for the company to continue paying and raising dividends.
• Low Dividend Payout Ratio: If a company’s payout ratio is too high, its dividend may be in danger. This ratio basically tells you what percentage of earnings is being used to pay the current dividend. Try to pick stocks for your watch list that have a payout ratio of perhaps 50% to 60% or less. This means earnings are sufficient to cover the dividend, and there’s also room for further increases in coming years.
• Low Debt-to-Equity Ratio: A company with a heavy debt load might be in serious trouble if business gets tough. Companies with less debt are better able to withstand recessionary periods, and are even able to continue to grow earnings because they aren’t burdened with huge debt payments. Try to find companies with as little debt as possible. A 50% debt-to-equity percentage or lower is a good number to shoot for.
• Below-Average P/E Ratio: As a value investor, I obviously gravitate toward low-P/E stocks. I try to focus on stocks with 12-month forward earnings estimates that are below the market itself. The S&P 500 is trading at about 19 times forward earnings right now, so I’ll look for stocks with P/Es below that number. I really favor stocks that are trading below 15 times earnings (historical average for the market), if possible.

The Technicals

My technical analysis comes into play only after I’ve located stocks based on fundamentals. I use technical analysis to help pinpoint safe entry levels, and to help avoid stocks that are extended.

• Near Support Levels: I try not to buy a stock that is greatly extended above a level of support where institutional investors have come in and bought it. The idea here is to reduce the probability that I’ll lose money on a purchase. If I know the level of strong support on a stock, I can somewhat accurately calculate my downside risk.
• Excellent Upside Potential: I like to focus on quality companies that are currently out of favor, for whatever reasons, and are likely to show significant price appreciation if they get their act together. These often trade near 10-year lows, but were once companies that traded 2 or 3 times higher than current levels.
• Good Price and Volume Action: A stock that’s acting right is one that has a pattern of heavier-volume buying on up days and light-volume selling on down days. I like to look at weekly price and volume charts to see if there’s evidence of institutional buying (or selling) in a stock. If the strong money has started to scoop up a dividend stock that I’ve been tracking, that’s a great time to step in. Without interest from institutional investors, a stock will have a difficult time sustaining an advance.

Here are a few stocks that appeal to me right now, based on both fundamentals and technicals:

• Nokia (NOK:NYSE ADR): This mobile-communications company has a great balance sheet with almost $10 billion in cash and basically no debt. Its yield is below 2%, but the company has consistently raised its dividend since 1994, a very healthy sign. Nokia has recently experienced a lot of buying by institutional investors, and it seems to have huge upside potential. It’s trading at about the same P/E multiple as the market itself: 19 times forward earnings estimates. It’s one of my favorite picks for performance over the next three to five years.
• Albertson’s (ABS:NYSE): This supermarket chain is an investment-grade stock with an excellent turnaround story. You might think that no one would buy this right now, given the labor problems in California. However, the stock has been accumulated, and it’s the only one of the three main grocers that’s moved up nicely since the strike began. (Kroger (KR:NYSE) and Safeway (SWY:NYSE) have declined.) Albertson’s is certainly a riskier play because its balance sheet isn’t fantastic – it has quite a bit of debt at 100% of equity — but its upside is tremendous if it can turn things around. It offers a good dividend at more than 3%, and great support exists at around $20. I’d consider buying it at present levels, trading at about 11 times forward earnings estimates, and I’d add to it if it dropped closer to support levels.
• Home Depot (HD:NYSE) : This home-improvement retailer has a great balance sheet with basically no debt. The yield is paltry at about 1%, but that’s still better than most money-market rates. It has a great history of raising dividends and a very low payout ratio of 13%, so there’s certainly room for further dividend increases in the coming years. The stock has excellent support at about $30, so the downside risk is limited. I’d consider buying this one at current levels and holding for the long run, three to five years.