An Income Portfolio for Retirees

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

A few years ago we hit an unusual milestone in the chronicles of investing: the average dividend yield of the S&P 500 exceeded the yield of the ten-year Treasury note for the first time in more than 50 years. In fact, in 2011, the average dividend yield of the S&P 500 hovered around 3.3 to 3.4 percent, more than half a percent higher than the ten-year Treasury note. As a result, investors began to pour money into the stock market. Share prices increased and yields decreased.

Risk and return

Most of us know that dividend-paying stocks are riskier than Treasury notes, which are generally used as the “risk free rate” (in other words the interest payment represents a return that an investor can expect to achieve while incurring no risk). After all, their stock prices can go up and down as a result of both the economy and the individual fortunes of the companies. But many of us forget that the price of bonds can go down too, especially longer-term bonds such as the ten-year Treasury note. And in contrast to bonds, many companies that pay a dividend choose to raise their dividends.

Reliable raisers

There are a handful of companies that pay meaningful dividends and that consistently raise their dividend payouts. With these companies, you not only get an attractive yield from the start but you also get generous raises over time. A company that raises its dividend by 10% on average, for instance, will roughly double its payout every seven years, whereas a company that raises its dividend by 20% will roughly double its payout every three to four years. These companies are also committed to increasing those payouts for years to come. So you can gain two ways: through dividends and share price appreciation.

Coming up with an “An Income Portfolio for Retirees”

To generate a list of reliable raisers I ensured that the following conditions were met: the company had to have a current payout of at least 2%; the company had to have stable operations; the company had to indicate a commitment to rewarding shareholders with dividends through words and printed materials; and the company had to have raised its dividend each of the past 10 years (or kept its promise to its shareholders). Then I removed utilities from the list and ensured diversification -- or ensured that various sectors were represented.

So what does this portfolio look like?

A diversified healthcare manufacturer

Abbott Laboratories (NYSE: ABT) is the largest company in the nutritional products market and is the third-largest producer of pharmaceuticals. With a beta of around 0.3, this company is as recession-proof they get. What’s more, Abbott continues to invest roughly 10% of its sales into research & development, which appears to have resulted in more than a fair number of innovative products with high margins. The major concerns are two-fold: new healthcare policies and patent expirations. Overall, similar to another company on this list, this company is splitting into two companies and that should unlock shareholder value and reward investors.

An iconic brand that cannot be replicated

Coca-Cola (NYSE: KO) is the largest beverage company in the world. On the positive side, Coca-Cola is arguably the most recognizable brand in the world; it has a balanced portfolio of products that consists of soft drinks, juices, juice drinks, energy drinks, coffees, teas, and packaged water; it has the potential to grow alongside large emerging economies such as China and India as per capita income rises; and it has raised its dividend each of the past 50 years. On the negative side, concerns about health and obesity are affecting sales, margins in some business lines are eroding, and competition is intensifying, particularly with PepsiCo, which has a joint venture with Starbucks and Unilever. Still, Coke offers a solid, predictable investment.

A company that will benefit from rising oil prices

ConocoPhillips (NYSE: COP) is the third-largest integrated energy company in the United States. This company has a solid track record; has unlocked value by separating into two companies; has excellent earnings, cash flow, and book value; and can often times be purchased at a discount relative to two other titans: ExxonMobil and Chevron. The major risks facing ConocoPhillips are geopolitical risk, discovery of alternative sources of energy or additional reserves, oil price volatility, and refining margins. Overall, though, oil stocks have a reliable track record of consistently delivering very strong results.

A diversified manufacturing technology company

3M Company (NYSE: MMM) is widely cited in business schools as one of the most innovative companies in the world. On the one hand, 3M has a diversified line of products, exposure to international markets, a culture that nurtures innovation, and the stock price is just now catching up with 3M’s performance over the past few years. On the other hand, this company is vulnerable to slowdowns in the global economy, is having trouble growing, and may engage in risky M&A activity to catalyze growth. All factors considered, there are few companies that balance stability and innovation the way that 3M does.

3 critical considerations

1. Climate: The climate for dividend growth continues to be favorable. More than 400 of companies in the S&P 500, for example, pay a dividend. And companies have a ton of cash on their balance sheets. Rather than hire commit to expensive wages or business investments that might not payout, many companies will reward loyal shareholders through dividends.

2. Price: These are all great companies. There is no doubt about that. But price matters -- a lot. In fact, I would not purchase any of these companies at an earnings multiple of more than 15 (and I want to see a multiple in the single-digits for ConocoPhillips). These companies are simply too large to grow in the double digits. Growing in the double digits for a $50 billion company means adding $5 billion in new business every year.

3. Dividend yield: All of these companies currently have dividend yields of more than 2% (through FY12). You can augment that dividend yield by selling covered calls where you give someone the right to purchase your shares from you at a price higher than they are currently selling at in the market over a finite time period for a price. If your shares never reach the strike price, then you pocket the price of the option less a small transaction cost. On the other hand, if the stock hits the strike price, then you also make a small profit through share price appreciation as long as the strike price is more than the price that you paid for the stock.

My foolish take

We all have different risk and reward tolerances. Although I do not feel that this investment strategy makes sense for me given my age and risk tolerance, it is similar to the investment strategy that my mother is currently executing -- and it makes perfect sense for her given that she is retired. Please also note that finding an attractive entry point is critical because right now many companies are fully valued.

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Ryan Peckyno has no position in any stocks mentioned. The Motley Fool recommends 3M. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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