10 for the Money

Special Report on Retirement: Folks approaching retirement should consider buying high-quality, dividend-paying stocks to bulk up their portfolios. Here are our top 10 picks.

THE WHIPSAWING OF SHARE PRICES OVER the past two years has left many investors anxious and uncertain. For the young, there’s plenty of time left to make up big stock losses. But for anyone who recently retired, or plans to do it soon, the 2009 rally has effectively applied a Band-Aid to a wounded pension portfolio that probably required a tourniquet.

Equity prices remain 30% below their 2007 highs. With Americans generally living longer, longevity risk — the chance that you’ll outlast your portfolio’s ability to support you — is rampant, with good reason: U.S. Census statistics indicate that the average 65-year-old man can look forward to nearly two more decades of life, with women likely to live even longer. All this points to the importance of investments that can withstand the long test of time. One of the most important groups is dividend-paying stocks, and Barron’s has identified 10 that look particularly good for the long haul.

Before we get into specifics, a little more background: A study of 1,000 Americans done by Scottrade in January found that 75% of the polled baby boomers — Americans born anytime from 1946 through 1964 — fear that full retirement won’t be an option for them. Says Scotttrade’s chief marketing officer, Chris Moloney: “They don’t have a lot of time to recover. The financial crisis [and the crushing stock swoon that ended last spring] has given them a one-two punch: a huge drop in their portfolios and a slow economy. With current living expenses, it has become difficult for them to add to their pension portfolio.”

These folks might be forced to alter their plans, accepting a lower standard of living in retirement. Says Susan Wilson, 61 years old, a database administrator for the University of New Mexico in Albuquerque: “The market has come back, but I’m still nowhere near where I was. I may work longer than I thought. And even when I’m done working, I’m not sure I’m going to have the life I pictured two or three years ago.”

If there is a silver lining, it’s that it is probably an auspicious time for buying and holding large-cap, high-quality, dividend-paying and dividend-growing stocks. “Right now, you can find leading blue-chip, high-quality stocks at below-average multiples that are raising dividends,” says John Carey, a fund manager at Pioneer Investments. That is all the more precious in a year that has seen some of the worst dividend cuts in a half-century. Standard & Poor’s says 78 companies have cut their payouts by a combined $48 billion in 2009. Last year, 62 trimmed their dividends.

Low-quality stocks, which generally don’t pay dividends, have been driving this rally, says Nicolas Simar, who runs the ING (L) Euro High Dividend Fund, “but in the rally’s second phase, the high-quality stocks will be the drivers.” And if the rally fades, they offer downside protection through their dividend income.

Matthew McCormick, a money manager with Bahl & Gaynor Investment Counsel in Cincinnati, argues dividend stocks are likely to outperform now because they have been laggards. “They offer stable earnings, and you can count on the dividend more than on capital gains or price appreciation” over any particular period of time, he adds.

Over very long periods, say 30 to 40 years, small-caps outpace large-caps due to higher growth potential. But this comes at a price retirees aren’t eager to pay: higher volatility. As Thomas Wilson, a principal in William Blair Private Wealth Management, puts it: “Volatility isn’t your friend when you need to make consistent withdrawals.”

Over 20 years — the period most retirees are concerned with — high-quality, large-cap dividend stocks often outpace the market on a risk-adjusted basis. They don’t rise as much in whiplash rallies, like the one we’re in, but they go down less when the market buckles. And with the oldest boomers beginning to retire, demand for them will rise, McCormick maintains, helping to support their prices.

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Dividends are important for any investor. Depending on which study is consulted, results show that payouts account for nearly half the total return of equities. And in some decades, like the 1930s, 1940s, 1970s and the current one, dividends are significantly more important than capital gains (see table nearby).

Of course, any retirement portfolio should be diversified and include things like commodities, small-cap mutual funds, Treasuries, real estate and perhaps even artwork and collectibles. On the equity/fixed-income side, the traditional rule of thumb has been for retirement portfolios to have a 60/40 split between stocks and bonds. But until the Fed starts raising interest rates, retirees should consider curbing the fixed-income portion of their portfolios. Because bond prices fall as rates climb, cheaper fixed-income investments will be available down the road. A 65/35 or even 70/30 tilt might be best now. Warns Jim Marlowe, a 61-year-old retired broker supervisor at Merrill Lynch: “Bond funds are where all the money is going right now, so when the market gets a whiff of higher rates, it’ll be ‘Katie, bar the door.’ ”

Adds Neil Dwane, RCM Allianz Global Investors’ chief investment officer for Europe: “An allocation of only bonds only works if you are already rich, or the pension pot is enormous.”

To determine how much income they’ll need, retirees must realistically estimate their health-care needs and probable longevity. Don’t forget the evil twins: taxes and inflation. Once a retiree has a plan, it’s important to stick to it. It’s also important to periodically rebalance the portfolio. “You can extend the life of your retirement portfolio by drawing income from the portfolio in proportion to the asset balance,” says Michael Weldon, who runs Lord Abbett’s investor and advisor education program. He advises taking money from your winners and rebalancing the portfolio to the initial allocation.

Which companies are worthy of a retiree’s income portfolio? Barron’s has selected 10 for the A team, plus a second 10 that didn’t quite make the cut, but easily could have. The A team is listed in the table, The Best Bets; the B Team is in the table, Lots of Bench Strength. Some top selections are American; some, foreign. Many yield more than 3% and raise their dividends regularly. In addition, they sport strong competitive advantages, healthy and sustainable cash flows and earnings, durability, sturdy balance sheets and attractive valuations. Our top picks:

Banco Santander (ticker: STD)

With many of the biggest U.S. and European banks in trouble or under pressure, this Madrid-based giant offers financial strength and geographic diversity. Last year, as other big banks snapped in the financial whirlwind, this mostly retail and deposits-oriented bank posted a 9% net profit increase to nearly nine billion euros ($13.3 billion). In 2009, once again it will probably be one of the world’s most profitable banks. The dividend yield on its Big Board-listed American depositary receipts is 4.2%.

Many U.S. investors don’t know much about Banco Santander, but that’s likely to change as the bank, the euro zone’s largest, expands in the U.S. through its Sovereign Bank unit. Santander, well-run for more than three decades by Chairman Emilio Botin, has about 14,000 branches in 16 countries, mostly in the Americas and Europe.

The stock trades at less than 11 times the consensus analyst earnings estimate of 1.08 euros ($1.60) a share next year. While Spain’s real-estate and construction markets are ailing, and European growth has slowed, Santander’s long-term future looks solid.

Chevron (CVX)

Big integrated energy outfits like this American oil explorer offer both a dollar hedge (because crude rises when the dollar falls) and exposure to two of the world’s most important commodities: oil and natural gas. Chevron, which yields about 3.5%, is seen earning $7.65 per share in 2010, up from an estimated $4.88 this year, but down from the $11.67 of 2008, when crude hit a record price close to $150 a barrel.

With crude-oil prices down about 47% since then, Chevron has stayed solidly profitable, steadily increasing both dividends and book value per share, while making 20%-plus returns on capital. The company has more than $9 billion in cash. Chevron is growing faster than many big global peers and “has a nice focus on renewable-energy businesses,” says Chris Tsai, who runs Tsai Capital in New York. “It’s also a good inflationary play, perhaps better than gold when tax-adjusted,” he contends.

Intel (INTC)

The premier maker of microprocessors, semiconductor chips, and sundry other computer and communications gear is involved in cyclical businesses, but that’s about the worst you can say about it. Intel is the 800-pound gorilla in the industry, and its manufacturing-scale and global-reach advantages would be hard to replicate, even in the tech world, where change happens quickly.

Sales bounce up and down over the years but eventually get higher through each cycle, as do profits, and dividends have grown an average 28% annually since 2004, the previous cyclical drop. Intel stock yields about 3.3%; this year marks the first time the yield has topped 3%. The company recently again raised its dividend, and there is probably more of that to come.

Donna Renaud, the lead portfolio manager of the Northern Large Cap Value Fund (NOLVX), for which Intel is a top holding, notes that it is trading around 13.2 times the 2010 consensus estimate of $1.48 a share, far below its average price/earnings multiple of 22. In the near term, global PC shipments should rise, and Intel has been boosting its gross margin guidance, which bodes well.

Johnson & Johnson (JNJ)

This is perhaps the quintessential dividend stock. While J&J was named the most respected company in a recent Barron’s poll, its stock doesn’t get the respect it deserves. J&J manufactures everything from Tylenol and Band-Aids to high-tech orthopedic hip replacements and coronary stents, and numerous pharmaceuticals.
J&J has arguably the best record of any major U.S. company in steadily growing its revenue, net income and dividends over many years. The stock yields 3.1% now, while the shares, in the low 60s, are off the high of 70 hit in 2008. Dividend growth over the past five years averaged 12%, which means return on equity is 25%-plus.

J&J has been trading at less than 13 times analysts’ consensus 2010 earnings estimates of $4.93 a share. Pioneer Investment’s Carey says that multiple is below both the company’s historical average of 17 and the overall market. “You just don’t see that kind of discount. Here you have a chance to buy it at a cheap price,” he says.

McDonald’s (MCD)

Because its shares haven’t done much in the past two years, few may know that the home of the Golden Arches has been the best-performing Dow industrial stock since 2002, up about 300% in that span. That’s when the world’s biggest fast-food chain slowed its expansion and redeployed its prodigious cash flow toward upgrading existing restaurants and menus, adding salads and fruits that customers wanted. All this boosted same-store sales sharply. McDonald’s continues to add new items, such as premium Angus burgers and McCafe coffee.

Despite Mickey D’s domination of a relatively recession-resistant industry, its revenue and net income growth isn’t always consistent. However, the stock yields about 3.5%, and dividends have grown nearly 30% annually over the past five years. Bahl & Gaynor’s McCormick says expansion outside the U.S., particularly in higher-growth markets like China, will help the fast-food chain over the long term and support its dividend.
Caveat: With 41% of operating earnings from Europe, McDonald’s has benefited from the surging euro. If the greenback strengthens, profit would be hurt.

Nestlé (NSRGY)

Like J&J, the Swiss behemoth is steady and solid as the tortoise in the race with the hare. The world’s largest food processor boasts wide product diversity and geographic reach, in the West and in fast-growing emerging markets, where the company is making a big push.

Nestlé has more than $100 billion in sales per year, but continues to gain market share in many of its markets and to experience mid-single-digit organic sales growth, an impressive task for a company that size. Its balance sheet is probably the strongest in the food industry, giving it the wherewithal to undertake bolt-on acquisitions.

The stock yields 2.6%, and dividends have grown over 11% annually for the last five years. For many companies this size, a P/E ratio of 15 times 2010 consensus estimates would be rich, but “Nestlé offers both a quality company and a dividend yield above the market average,” says Christoph Riniker, a senior strategist at Bank Julius Baer.

Novartis (NVS)

This leading manufacturer of drugs — from cardiovascular medicines like Diovan to oncology and neuroscience compounds, as well as vaccines and diagnostic tests and over-the-counter products such as Excedrin — also gives international exposure and would help diversify a retirement portfolio away from the dollar.
The Basel, Switzerland-based firm’s American depositary receipts have a dividend yield of 3.2%, and the payout has risen, on average, 15% annually over the past five years. At less than 12 times consensus 2010 earnings estimates of 4.63 Swiss francs ($4.55), Novartis is cheap, compared with the market P/E and its own average historical multiple of 18.

While investors fret about the coming loss of patent, in 2011, on best-selling blood-pressure medication Diovan, sales of new drugs such as Galvus for diabetes and Tekturn for hypertension are building. In the near term, Novartis’s H1N1, or swine flu, vaccine should boost results. Novartis’ agreement to buy Alcon before August 2011 from Nestlé at a potentially rich price also worries some investors. But Novartis is good at cutting costs, and its sales are likely to keep growing in the high single digits.

PepsiCo (PEP)

In the never-ending cola wars, PepsiCo is our selection because it offers a bit more sales growth than Coca-Cola (KO), which made our second list.

PepsiCo is expanding in fast-growing markets like Russia and China, and through the introduction of new products like naturally sweetened beverages, in an already-diverse portfolio, according to Bahl & Gaynor’s McCormick. Its dividend, which represents a 2.9% yield, has risen at a 17.5% annual clip over the past five years. The stock trades at 15 times consensus EPS estimates of $4.22 next year, but the company is one of the fastest growers in this portfolio. Return on equity has consistently hovered around 30%, and earnings are “extremely stable,” McCormick adds.

That’s music to a retiree’s ears.

Procter & Gamble (PG)

Cincinnati-based P&G is another of the U.S.’s great franchises, with a widely diverse manufacturing, product and customer base around the world. It would be difficult to find a country where it doesn’t either make or sell one of its laundry, beauty-care, food or health-care products.

The stock is just below the market multiple and little changed for the year, with a 2.8% yield, the highest it’s been in some time, notes Pioneer’s Carey. “It’s a strong company in a lot of business areas.”

Sales fell for the fiscal year ended June 2009, a rare occurrence, and there are some worries about people trading down in a recession. However, P&G still managed to boost earnings again, and it continues to gain share in lucrative growth markets. It’s also adept at cutting costs.

Both the stock price and the projected 2010 P/E of 15 times earnings are far below the company’s historical average. Over the past five years, the dividend has grown by an annual average of 12%.

Verizon Communications (VZ)

This telecom has the highest dividend yield in our bunch, 6.2%, because many investors fear it eventually won’t be able to replace revenue from the industry’s ongoing loss of land lines.

But through its Verizon Wireless joint venture with Vodafone (VOD), Verizon is the largest U.S. wireless-service provider, notes Darren Pollock, a portfolio manager at Cheviot Value Management. “Verizon continues to add wireless subscribers at a good clip, even without the ability to offer hot products like Apple’s iPhone.” Its network is generally considered the most reliable in the U.S.

Verizon has begun selling the Droid, a mobile phone that runs on the Android operating system (see Gadget of the Week). Meanwhile, AT&T’s (T) exclusive deal to sell the iPhone in the U.S. (see related story) could end by June, after which Verizon might sell the Apple product. That could be a huge boost for its wireless business.

The securities discussed in the posted article are current holdings of Cheviot’s clients. The viewer should not assume that investments in the securities identified and discussed were or will be profitable and it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. All information is provided for informational purposes only and should not be deemed as a recommendation to buy the securities mentioned. Cheviot closely monitors its positions and may make changes to the portfolio’s investment strategy when warranted by changing market conditions. If a security’s underlying fundamentals or valuation measures change, Cheviot will reevaluate its position and may sell part or all of its position. There can be no assurance that Cheviot’s clients will continue to hold the same position in companies described herein, and their portfolio positions may change at any time.
For additional Information:
·         Recommendations made by Cheviot during the previous 12 months
If you have any questions on specific recommendations mentioned in the list, please contact Cheviot.
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