Given the huge drops across the board last week, there are a lot of excellent companies that are now on sale. With all of the attractive bargains out there, it's been a bit of an overload for me deciding what my actions should be. As mentioned in Friday's post, I plan on adjusting some of my holdings to take advantage of these better prices. Here is my current thinking.
Cash and Fixed IncomeIt's relatively expensive to hold cash. CDs and internet
bank rates are currently in 2-4% range, and probably will trend lower over the next few months if the central banks continue to lower rates. Adjusted for inflation, the real return here is practically 0% if not negative. The yield on
TIPS is less than 2%.
Likewise, bond yields are also quite low. Vanguard's
Total Bond Market index is yielding less than 5%.
Dividend StocksMeanwhile, dividend yields on some very solid companies are trading above bond yields and at multiples over the cash interest rates. Now this assumes that these companies will continue to pay out their dividends. That's why a lot of financial companies have implied dividend yields that have skyrocketed in the past few months to reflect the low level of confidence that investors have in those dividend payments.
However, the most conservative companies will raise their dividends on an annual basis. Standard and Poor's actually maintains a list of these companies, calling those that have consistently increased their dividends every year for 25 consecutive years
Dividend Aristocrats. Here is a good
summary on the Dividend Aristocrats Series and an Excel spreadsheet containing a list of the current U.S. S&P 500 Dividend Aristocrat
constituents. The benefit here is that a well selected basket of dividend stocks will steadily increase their payments every year, meaning that the yield at initial investment cost will increase dramatically as well. This is in addition to any capital appreciation in the stock, which is generally quite favorable since an increasing dividend is a reflection of a strong underlying business.
Consequently, I'm going to allocate about half my portfolio to construct a dividend portfolio. The keys will be my assessment of the strength of their business and market position, their track record of dividend increases, the ratio of their dividend payment to their free cash flow, and their cash reserves. Here are the names I'm considering:
- 3M (MMM) - 3.5%. Existing position.
- Diageo (DEO) - 5.5%. New holding and increases international exposure. They control most of the premier liquor brands, including Smirnoff, Johnnie Walker, Captain Morgan, Bailey's, Guinness, and Dom Pérignon, among many others. My one qualm is their debt position, as they have 2x debt to equity ratio. However, this is consistent with their historical levels and is comparable to other companies in the industry like Anheuser-Busch and Constellation Brands. Also, their business should be fairly consistent regardless of economic environment and they should be able to continue to pay off their debts via their free cash flow.
- Johnson and Johnson (JNJ) - 3.0%. New position. I've always admired this company and I'm glad there's an attractive price now to start this position.
- Nokia (NOK) - 4.7%. New holding and increases international exposure. Internationally, they are still quite dominant but the price has come down significantly. There are competition issues but their cash levels and track record is excellent.
- Pfizer (PFE) - 8.5%. Will likely add to this position at these levels to take advantage of the high yield. I've already written about how much cash they have to support this.
Here are some other names that I would consider. I think a basket of these will do quite well and generate a solid stream of passive income.
- Automatic Data Processing (ADP) - 3.5%
- BP PLC (BP) - 8.3%
- Bristol-Myers Squibb (BMY) - 7.1%
- Coca-Cola (KO) - 3.7%
- Freeport-McMoran Copper & Gold (FCX) - 5.5%
- General Electric (GE) - 5.8%
- GlaxoSmithKline (GSK) - 5.9%
- ING Groep NV (ING) - 17.7%
- Kimberly Clark (KMB) - 4.1%
- Kraft Foods (KFT) - 4.3%
- McDonald's (MCD) - 3.7%
- McGraw-Hill (MHP) - 4.0%
- Merck (MRK) - 5.8%
- NYSE Euronext (NYX) - 4.6%
- Paychex (PAYX) - 4.4%
- Sanofi-Aventis (SNY) - 6.1%
- Santander (STD) - 5.3%
- Unilever (UL) - 4.5%
- Vale (RIO) - 4.3%
- VF Corporation (VFC) - 3.7%
Value StocksThe other half of my portfolio will consist of undervalued stocks in which the dividend, if there is one, is not as significant.
NVIDIA, Columbia and Giant Interactive have all traded down, and I will look to add more to these positions, particularly NVIDIA. I will likely exit my positions in eBay, Whole Foods Markets and perhaps Intel and Heartland Payment Systems in order to raise capital to do this.
While I am still bullish long term on eBay and Whole Foods, both have fundamental business issues to contend with. eBay has to respond to the decline in growth of their auctions/marketplace business as well as the rise in competition from Amazon and Google. I'm also not sure about their recent
acquisition of BillMeLater at over $1B in this environment. Whole Foods faces more direct challenges from the economy and also may have overextended itself in its recently
scaled back expansion plans. I think both are trading at very attractive prices that reflect these issues, but I'd rather have the cash for other investments.
Similarly, there's nothing wrong with Intel, and their dividend yield has even increased to 3.7%. However, I think the appreciation potential is limited, and that a double many years out at best. I would rather put that money in NVIDIA.
As for Heartland, the stock has held up admirably given that it's in the financial sector and deals with
credit cards, which is widely believed to be the next shoe to drop in the credit crisis. However, the business is impacted more by the use of credit cards rather than the extension of credit lines, but the market may not care. The company has set some ambitious goals for itself as
discussed before, and it currently has a very attractive valuation. I think I'm more likely to buy more but may look to sell this for other opportunities, particularly if the company's results and outlook deteriorates dramatically as a result of the crisis.
Berkshire Hathaway is a significant chunk of my portfolio, but I lump this in with the relative "safety" half of my portfolio that consists of dividend stocks.
OptionsI made an uncharacteristic trade on Friday, dabbling in 1 call contract on the S&P 500 that expires in November with a strike price of 900. I plan on exiting this position this coming week, and very likely will do it Monday morning. I normally avoid these sorts of short-term, high volatility trades. However, if there appears to be a significant dislocation in the market, then I'll look to take a small position. Right now, European markets and S&P 500 futures are up over 5% as I write this, due to the stream of positive
government announcements over the weekend, which bodes well for a solid return from this move.
I will probably continue to make opportunistic trades here, but will keep this to 5-10% of my portfolio. I will keep to highly liquid options, which means only on the major indices and the bluest of the blue chips.
Two for the IRAThe TogaPF portfolio is a taxable account, but here are 2 ideas for tax-advantaged accounts:
- American Capital (ACAS) - At Friday's close, this had a dividend yield over 30%. As a business development company, they are required to distribute 90% of their income to investors every year, but they do not have to pay any taxes at the company level. At the shareholder level, however, the investor needs to treat the dividend income as ordinary income, so it makes sense to own this in a tax-advantaged account. I've been trying to figure out the catch to this, but so far I haven't been able to find anything. Their track record of dividend payments has been absolutely astounding; they've raised it every quarter since their IPO. The Company's shareholder materials spend a lot of time assuring investors that the dividend is safe. I particularly like that they allocate cash generated this year to fund next year's dividend payout. As a private equity company, it's taken quite a hit along with the rest of financial sector. The blog posts and links referenced in the Top Bull Pitch writeup in CAPS have been very helpful in breaking down the company for me.
- Kinder Morgan Partners (KMP) - This is the leading natural gas pipeline company in the U.S. with a dividend yield over 9%. They basically control the bulk of the distribution of natural gas in the U.S. Here is a writeup from the Motley Fool.
ConclusionUnless the market rebounds dramatically this week, I will likely be close to 100% in the market by Friday. I still think that the markets have some room to decline, but current prices are attractive enough for me. I also plan on putting in additional funds in the next few weeks to take advantage of these conditions.
