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10 Dividend Stocks Most Likely to Outperform

NEW YORK ( TheStreet) -- Had you invested equally among each of the 30 stocks that currently comprise the Dow Jones Industrial Average, from September 2000 to September 2010, your portfolio would have returned 3.15% annually*.

Had you invested equally among the 42 stocks that currently comprise the S&P 500 Dividend Aristocrats -- an index composed of large-cap S&P 500 companies that have increased dividends for 25 consecutive years -- you would have enjoyed a 8.1% annual return.

Alas, the Dividend Aristocrats are not infallible.

Presently, eight Dividend Aristocrats fail to meet the criteria of our dividend acid test. These eight stocks have the greatest mathematical likelihood of dividend stagnation, and subsequently, the greatest risk of being dropped from the index.

In 2009, 10 stocks were dropped from the Dividend Aristocrats -- collectively, the annualized 10-year return for these "fallen angels" was 2%. As the data suggests, knowing which stocks to avoid can have a pronounced impact on investor returns.

In the past we've attempted to select a small portfolio of Dow stocks intended to outperform the collective future performance of the 20 best-performing Dow components. Using the same criteria -- with two new additions -- we've narrowed our universe of Dividend Aristocrats to 10 stocks, each with a reasonable chance of outperforming the composite index:

1.) Each stock must have a liability-adjusted cash flow yield** greater than the yield of a 10-year U.S. Treasury note.

The expected rate of return of the equity should exceed the risk-free rate of a Treasury note, preferably, by a ratio of 2-1 (to compensate the owner for business-specific risks).

2.) Each stock must have a return on invested capital greater than 10% (using 10-year historical data).

Return on invested capital measures the success and failures of a company's capital expenditures -- a direct measure of managerial competence. Ten percent is a reasonable minimum figure to ensure that management is spending capital wisely.

3.) Each stock must show a positive total return (including dividends) over the past 10 years.

For an individual investor, 10 years represents a large percentage of his or her "investable lifetime." Ultimately, if the managers of a profitable company are unable to return profits to shareholders in a decade's time, something is wrong. Or, as Benjamin Graham writes in The Intelligent Investor, "poor managements produce poor market prices."

New -- 4.) Each company must have a five-year average tax rate greater than 25%.

Companies with tax rates below 25% likely enjoy the benefits of deferred tax assets and/or government tax subsidies -- however, a cautious investor must not assume preferential tax rates will continue indefinitely.

New -- 5.) Each company must have a "quick ratio" greater than 1.

Companies with a quick ratio below 1 have weak liquidity and often rely on rapid inventory turnover and/or credit facilities for daily operations. In the event of a crisis, these companies will be most susceptible to operational deficiencies.

It is worth noting that each of the 10 securities that met our established criteria have been rated "Buy" by the TheStreet's proprietary stock ratings model.

*Total return does not include the impact of taxes and trading costs. Total return data only provided for securities currently listed in each respective index. Data provided by Yahoo! Finance via BuyUpside.com.

**To determine liability adjusted cash flow yield, a "short formula" was used, defined as:

5-Year Average Free Cash Flow / ((Outstanding Shares x Per Share Price) + (Liabilities - Cash))
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