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While pundits say that you should have about 30 stocks for a fully diversified portfolio, truth is, it's fairly difficult for an individual investor to track and manage 30 stocks. It's a lot easier to manage between 5 and 15 stocks. So I like breaking my asset allocation strategy into little chunks where I can build mini-portfolios for each piece. For example, for low-risk dividend income, capital growth and capital preservation for retirement, I would have done well, and still will, with a small diversified portfolio of the following five dividend cash cows - IBM (NYSE:IBM), Chevron (NYSE:CVX), AT&T (NYSE:T), 3M (NYSE:MMM) and PepsiCo (NYSE:PEP) - spread across information technology, oil and gas, fixed and wireless communications, materials and consumer foods and beverages.

I've picked these five for their rock-solid dividend performance, inexpensive valuation ratios relative to the past ten years, fundamental business strength, strong operating history over the past few decades and robust growth prospects over the long run.

Dividend Aristocrats

Of the five dividend cash cows, all but IBM are on the S&P 500 2013 Dividend Aristocrats Index - an exclusive up-to-date list of 54 companies that have consistently raised dividends for each of the past 25 years.

As the table below shows, over the past 20 years, these dividend cash cows have raised dividends between 4% and 15% and have fairly high dividend payout ratios that range between 32.6% at the low end and 63.4% at the high end. And while their current yields are not excessive and range from a modest 2.1% to a reasonable 5.3%, the sums of their current yields and annual dividend growth rates are very compelling, ranging from 8% (MMM) at the low end to 17% at the high end. It is this combination of steady dividends and sustained dividend growth that I find compelling for reliable dividend income for a retirement portfolio, where you can rest easy knowing dividends are pretty much guaranteed with these five.

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I also like these stocks because of their sustainable dividend payout ratio and steady dividend growth. Sustained dividend payouts indicate management comfort with future earnings, cash flow, liquidity and balance sheet strength. Steady payouts also result in a smaller cash build up on the balance sheet and reduces management's tendency to do something big with it at the expense of shareholder value. So, as a shareholder, I much prefer regular dividend payouts and share repurchases than having management retain money they do not need. Moreover, when a company raises dividends, demand for its shares typically rises and its share price often (not always) increases.

Dividend Value Strategy

Dividends are a key component of what's called the Dividend Value strategy where stock selection is first based on dividend strength followed by valuation soundness based on price-to-earnings and price-to-book ratios.

The table below (from FastGraphs.com) lists the five dividend cash cows in order of projected performance over the next five years. All of these stocks trade roughly in-line with or lower than their normal 10-y price-to-earnings ratios, and below the S&P 500 average P/E of 18.8.

At a P/E of 11.4, IBM is undervalued relative to its normal 10-y P/E because investors recently beat down shares on disappointing Q2 results to levels that seem very attractive for the long run. IBM's earnings are projected to grow at about a 10% rate going forward and, with dividends, IBM is expected to deliver a 17.5% annual total return, with shares projected to more than double over the next five years to just above $400.

Chevron currently trades in line with its historical P/E, is expected to grow earnings at 6.8% going forward and deliver a 16.2% annual total return with shares projected to double by 2018.

AT&T lags on P/E but is expected to grow at a slightly higher pace than it has over the past ten years, with 13% annual total return over each of the next five years, including dividends. AT&T shares are expected to cross $50 by 2018, up about 50% from their current level.

3M and PepsiCo are projected to deliver robust annual total returns of 10% and 7.2% respectively, with modest gains in share price by 2018. While 3M and PepsiCo's returns may not seem desirable, on a risk-adjusted basis their 10% and 7.2% return projections handily beat inflation and are still an investor's best friend, specially one seeking virtually assured dividend income and minimal downside risk because, fundamentally, each of these companies has a solid moat that protects its revenue and cash flow from competitive forces.

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Look Beyond Share Price to Total Returns

Now, some would point to the chart below and argue that PepsiCo and 3M have barely kept up with the S&P 500 over the past 10 years and that AT&T has actually lagged. And while it's true that AT&T shares only rose 2.6% per year over the past 10 years compared to a 4.1% annual rise for the S&P 500, when you factor in dividends paid (not reinvested), AT&T delivered a 6.3% total annualized rate of return versus a 5.3% dividend adjusted return for the index.

PepsiCo delivered share price appreciation of 5.8% annually (versus 4.1% for the index) with a 7.5% total annualized return. 3M, however, lagged the index on share price appreciation with a 3% annual gain (versus 4.1% for the index) and also lagged on total annualized return with 4.5% versus 5.3% for the index.

So factor in dividends and annual total returns into stock selection decisions. Now, while 3M lagged the index even on total return, it is expected to deliver a 10% annual return over the next five years, which likely will beat the index going forward. While past performance is important, 3M's projected future earnings make it attractive for dividends and capital gains.

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Moreover, weakness over the past month offers fresh buying opportunity as each of these five has dipped between 2.5% and 6%.

Share Repurchases

In addition to dividends, these five companies significantly increase shareholder value through regular multi-billion dollar annual share buyback programs and significantly reduce float (outstanding shares). With fewer shares outstanding, earnings per share rise and make outstanding shares more attractive. While the dividends v. buybacks debate will rage on, buybacks have tax advantages and increase shareholder value, provided shares are repurchased at reasonable valuations.

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Cash Flow Kings

At the end of the day, dividends and buybacks come out of cash flow, which these five companies have oodles of. At the low end, 13% of PepsiCo's revenues convert into operating cash flow and at the high end, 30.7% of AT&T's revenues flow to operating cash, 63.4% of which is paid out as dividends and a substantial portion of the balance is used to buyback shares. Companies such as AT&T are classic cash cows where their existing infrastructure investments continue to throw off cash over long periods of time. AT&T tops the list on operating cash flow with $39.2 billion generated in fiscal 2012, closely followed by Chevron with $38.8 billion.

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Solid Balance Sheet, Credit Rating

I also like these five stocks for a retirement portfolio because they offer sizable upside with relatively little downside. While all of these companies have jumped onto the debt wagon because interest rates are at all time lows, in no case does debt exceed 30% of assets. Moreover, interest expense is fairly low as a percentage of operating cash flow. At the high end, PepsiCo's interest expense consumes 11% of its operating cash flow, which is excellent from an interest coverage perspective, with debt posing little threat of bankruptcy. As a result of strong balance sheets, these companies have solid investment grade credit ratings from A- to AA (CVX, MMM).

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Shares Offer Significant Price Appreciation Potential

Based on FastGraphs estimates (which are further based on consensus analyst growth estimates), PepsiCo shares, including dividends, should deliver a 7.2% annual total return over the next five years with a projected price target of about $100, not factoring in the effect of buybacks. On the high end, IBM shares are expected to more than double with a 17.5% annual return through 2018. On average, this portfolio should offer solid double-digit returns for each of the next five years, handily beating inflation and likely also exceeding the S&P 500.

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Excellent Management Effectiveness

For the five cash cow stocks listed here, management performance has mostly been excellent with solid double-digit returns on assets, equity and invested capital, with the exception of AT&T, which has struggled in the face of competitive pressures in a maturing market. IBM leads with rock solid returns and a clear leadership position in technology services.

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Summary

A dividend value strategy makes stock selection easy, and when combined with these Dividend Aristocrats and cash flow kings, is perhaps the best way approach to generating solid long-term returns for retirement. While the share price projections presented above factor in earnings growth and dividend increases, they do not factor in additional upside from dividend repurchases that all of these companies actively do. With all five shares down over the past month, this is a good time to initiate positions because with dividends and earnings gains, this mini-portfolio will very likely deliver solid returns over the next five years, especially as U.S. and global economies stage a comeback.

Source: Dividend Cash Cows For Stable Retirement Income And Capital Growth