10 Stocks for Building a Diversified Income Portfolio (Part 1)

Christopher is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As an income-focused long-term value investor I am a firm believer in building strong income based diversified stock portfolios that not only deliver a solid recurring income stream but also have the potential to generate long-term capital growth. In order to do this it is not just about targeting those stocks that pay massive dividend yields like Annaly (NLY) with a yield of 14% or Capstead (CMO) with a yield of 13%. It is about building an interlocking investment portfolio where each stock compliments the others' style and where the overall dividend yield exceeds, in my opinion, the two key earnings requirement, the rate of inflation and the risk free rate paid by 10-year treasuries. My goal with constructing this portfolio is to generate an average return across the portfolio of 4%, which is double the yield of ten year treasury bonds and higher than the December 2011 U.S. inflation rate of 2.96%. As this is a diversified yield portfolio I have selected one solid dividend-paying stock from each of the major sectors, including financials, energy, healthcare, technology, industrials, consumer staples, consumer discretionary, telecommunications, utilities and materials. In this article I will set out the first five stocks selected from the first five sectors.

Westpac Bank Corporation (NYSE: WBK)

My first pick is for financials and I have gone out on a bit of a limb and selected Westpac, a bank from Australia that is dual listed on the NYSE and ASX. I have chosen Westpac as it has a solid dividend yield and consistent earnings. Westpac is Australia’s second largest bank and the 39th largest in the world and has a market cap of $65 billion. It provides the full range of banking, financial and wealth management services. It has a 52 week trading range of $89.41 to $138.57 and is now trading at around $111, with a trailing P/E of 9.

Westpac pays a solid dividend yield of over 7%, which is higher than direct competitors such as ANZ (ANZ.AX), and the Commonwealth Bank (CBA.AX), both of which don’t pay a dividend on their NYSE dual listed stock. This yield is also a lot higher than the major U.S Banks such as Wells Fargo’s (WFC) 1.60%, JP Morgan’s (JPM) 3%, Bank of America’s (BAC) 1% and Citigroup’s (C) 0.10%. It has a return on equity of 17%, which is higher than ANZ’s 15%, similar to Commonwealth Bank’s 18% and superior to Wells Fargo’s 12%, JP Morgan’s 11%, Bank of America’s 1% and Citigroup’s 7%.

Westpac saw a 3% rise in first half 2011 earnings to $19 billion, and during this period net income dropped by 23% to $3 billion. For the same period Westpac’s balance sheet strengthened with cash and cash equivalents rising 77% to $27 billion and long-term debt dropped 17% to $144 billion.

Westpac’s dividend yield of around 7% meets my yield criteria as it is higher than current bond yields and twice the U.S. inflation rate for December 2011. The company also has a strong dividend payment history, having consistently paid a steadily rising dividend since 2001, which only dipped with the GFC. This dividend has increased by 402% since 2001 to its current value of $7.94. It also has the dividend well covered with a payout ratio of 71%.

Overall the outlook for Australian banks is quite positive with Moody’s in December 2011 stating that it is maintaining its stable outlook. Moody’s highlighted the solid fundamentals of the Australian banks and the strength of the domestic economy. This in my opinion combined with Westpac’s cash holding of $27 billion, can only bode well for Westpac and its ability to continue consistently paying dividends.

Finally at current prices I believe the stock is undervalued as it has an earnings yield of 11%, which is more than triple the risk free rate of ten year Treasury bonds.

Enterprise Products Partners (NYSE: EPD)

My next pick is in the energy sector and I have selected Enterprise Products Partners. The company provides midstream energy services to producers and consumers of natural gas, crude oil, refined oil products, and petrochemicals in North America. It has a market cap of $43 billion and a 52-week trading range of $36 to $4.70. It is now trading at around $49 with a trailing PE of 25.

Enterprise Partners is a strong contender for this portfolio when compared to its competitors. Its dividend yield of 5% is higher than Chesapeake Energy’s (CHK) 1.6% and Cabot Oil’s (COG) 0.1%. It also has a solid return on equity of 13%, which is higher than both Chesapeake Energy’s 11% and Cabot Oil’s 8%. 

The company has also seen in the third quarter 2011 a 0.6% rise in earnings to $11.4 billion and a 9% increase in net income to $471 million. However, for the same period its balance sheet weakened with cash and cash equivalents dropping 52% to $108 million and long-term debt rising 4% to $14 billion.

The earnings outlook for the oil and gas pipeline industry is quite positive with demand being driven by growth in the Chinese economy and the increasingly positive outlook for the U.S economy. All of this bodes well for increased earnings growth for oil and gas suppliers such as Enterprise Partners.  

Enterprise Partners dividend of $2.48 per share is a solid yield of around 5% and this is greater than both the current yield of ten year Treasury bonds and the U.S inflation rate for December 2011. The company also has a history of paying a consistently increasing dividend since 1999, which has risen by 158% to its current value. I also find the stocks beta of 0.53 quite appealing from a yield perspective as it indicates that its stock price is considerably less volatile than the market, which bodes well for protecting investment capital.

At current prices the stock appears to be reasonably valued by the market with an earnings yield of almost 4%, which is roughly double the risk free yield of ten year Treasury bonds. However, I am expecting earnings to grow, as the company’s profit margin of 4.16% is higher than the five-year average profit margin of 2.18%.

AstraZeneca (NYSE: AZN)

When building a diversified income-generating stock portfolio the healthcare sector forms an important part due to the characteristics of the major pharmaceutical stocks, all of which have consistent earnings, pay consistent dividends and generally have low price volatility. My pick is AstraZeneca, which is one of the largest pharmaceutical companies in the world and has a market cap of $63 billion. It discovers, develops, and commercializes prescription medicines for cardiovascular, gastrointestinal, infection, neuroscience, oncology, and respiratory and inflammation diseases worldwide. The company has a 52 week trading range of $40.89 to $52.54 and is now trading at around $48 with a trailing PE of 7.

AstraZeneca pays a dividend yield of 3.6%, which is higher than most of its industry competitors and greater than favored dividend stalwarts such as Johnson and Johnson (JNJ) with yield of 3.5% and Abbott Laboratories (ABT) with a yield of 3.4%. It also has a superior return on equity of 44%, which is the highest in the industry and higher than Johnson and Johnson’s 19% and Abbott Laboratories 19%.

For the third quarter 2011 AstraZeneca saw a 1% fall in earnings to $5 billion, but a massive 66% rise in net income to $2.2 billion. For the same period AstraZeneca’s balance sheet strengthened with cash and cash equivalents rising 8% to $7 billion and long-term debt falling 17% to $4.8 billion.

The company is currently paying a dividend of $1.70 per share, which is a solid yield of around 3.6% and it has been consistently playing a dividend since 1993. The company also has its dividend payment well covered with a low payout ratio of only 39%. AstraZeneca also has a conservative debt to equity of 0.39, which in conjunction with its stronger balance sheet bodes well for maintaining dividend payments. I also like the company’s moderately low beta of 0.66, which makes it an ideal defensive stock for weathering further market volatility and economic headwinds.

Despite trading at close to its 52 week peak, its earnings yield of almost 15% is more than triple current ten year Treasury bond yields. This in my opinion indicates that the stock is still undervalued at current prices. For all of these reasons I believe that at its current price the company is a solid dividend play in a diversified dividend investment portfolio.

Intel (NASDAQ: INTC)

To ensure that the diversified nature of the portfolio is maintained my next pick is in the technology sector. Who better to select than an industry stalwart like Intel which is the largest semiconductor manufacturer in the world with a market cap of $124 billion? Intel has a 52-week trading range of $19.16 to $25.78 and is currently trading at around $27, with a trailing PE of 11.

From a dividend yield perspective Intel is one of the better dividend yielding stocks in its industry with a dividend yield of 3%. This is the fourth highest yield in the semiconductor industry and higher than Texas Instruments’ (TXN) 2% and Cypress Semiconductor’s (CY) 2%. Its return on equity of 27% is the eighth highest in the industry and greater than Texas Instruments’ 21% and Cypress Semiconductor’s 24%.

Despite a subdued demand for semiconductors and related products Intel has seen third quarter 2011 earnings rise 8% to $14 billion and net income rise 17% to $3.5 billion. Its balance sheet strengthened during this period with a massive 52% increase in cash and cash equivalents to $7 billion. When this is considered with a low payout ratio of 33% it is clear that Intel has its dividend well covered and this bodes well for dividend stability.

Intel also has a PEG ratio of 0.45, which bodes well for future earnings and net income growth. When these are considered in conjunction with Intel’s extremely conservative debt to equity ratio of 0.15 and substantially stronger balance sheet, the company is not only strongly positioned for future growth, but is capable of weathering any further economic headwinds.

Finally with an earnings yield of 9%, the stock appears undervalued when compared with the current risk free yield of ten year Treasuries. Overall Intel’s fundamentals show a solid company that is well placed to maintain its dividend as well as increase earnings and net income with any cyclical uplift in the global economy. This gives investors not only a consistent income stream but the opportunity for capital growth.

Lockheed Martin Corporation (NYSE: LMT)

For the first half of the portfolio my final pick is in industrials. What better part of the sector to choose than the defense industry and the largest defense contractor and military aircraft manufacturer, Lockheed, which has a market cap of $26 billion? It also has a 52 week trading range of $66.36 to $83.71 and is now trading at around $82 with a trailing PE of 10.

Lockheed’s dividend yield of 5% is the highest in the defense industry and is greater than Boeing’s (BA) 2% and Northrop Grumman’s (NOC) 3%. Its return on equity of 86% is also the highest in the industry, higher than both Boeing’s 85% and Northrop Grumman’s 16%.

The majority of Lockheed’s earnings are derived from U.S. Government contracts and this has been historically high due to major U.S. military missions in the Middle East, as well as the need to update aging and obsolescent defense equipment and systems. For the third quarter 2011 Lockheed saw a 5% rise in earnings to $12 billion, but net income dropped by 6% to $700 million. For the same period Lockheed’s balance sheet strengthened with cash and cash equivalents rising 40% to $4.6 billion, although long-term debt rose 30% to $6.5 billion.

Lockheed has a history of consistently playing a rising dividend since 2003, with the dividend increasing by 590% over that time to its current value of $4. When this is considered in conjunction with a payout ratio of just 36%, it is clear that Lockheed is in a position to sustain its dividend payments.

In my opinion Lockheed is a perfect addition to the portfolio as it adds a degree of earnings stability and diversification. It also has a moderately low beta of 0.86, which makes its stock price less volatile than the market. This in my opinion makes it an ideal income generating stock as this reduces the risk of capital loss.

Finally despite Lockheed trading at close to its 52 week peak, its earnings yield of almost 11% is more than triple the current risk free rate. This makes me believe that Lockheed is undervalued at its current price and will provide income hungry investors with the opportunity for capital growth as the stock price increases.


DividendKings has no positions in the stocks mentioned above. The Motley Fool owns shares of Lockheed Martin and Intel. Motley Fool newsletter services have recommended buying shares of Intel and Enterprise Products Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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