Top 5 Stocks For A Roth IRA

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 |  Includes: KO, MCD, MO, O, T
by: Steve Nicastro

The most popular way to invest in a Roth IRA account seems to be investing in a low-cost, diversified ETF. This strategy is not a bad idea - if you choose the right ETF, you will get diversification and yield that should produce decent results over time. However, I urge investors to consider putting a number of dividend paying stocks to their Roth IRA to maximize returns. You simply cannot get the same amount of upside in an ETF that you can get in a stock. If you start with a stock that already yields at least 3 percent and a stock that is likely to keep increasing their dividend, you are getting all the benefits of compound interest tax-free, and you are probably going to be very happy at retirement.

Even if you don't agree with my stock selections, my best advice here is to just start a Roth IRA - the earlier, the better. Remember, you are getting tax-free returns at retirement. You can also withdraw your contribution any time, tax free and penalty free (but not your earnings). The max contribution amount a year is $5,000.

Start Now - The Sooner the Better

Starting just a few years earlier can result in tens of thousands of dollars gained because of the power of compound interest.

Here's a great example from Investopedia:

"Consider two individuals, we'll name them Pam and Sam. Both Pam and Sam are the same age. When Pam was 25 she invested $15,000 at an interest rate of 5.5%. For simplicity, let's assume the interest rate was compounded annually. By the time Pam reaches 50, she will have $57,200.89 ($15,000 x [1.055^25]) in her bank account.

Pam's friend, Sam, did not start investing until he reached age 35. At that time, he invested $15,000 at the same interest rate of 5.5% compounded annually. By the time Sam reaches age 50, he will have $33,487.15 ($15,000 x [1.055^15]) in his bank account.

What happened? Both Pam and Sam are 50 years old, but Pam has $23,713.74 ($57,200.89 - $33,487.15) more in her savings account than Sam, even though he invested the same amount of money! By giving her investment more time to grow, Pam earned a total of $42,200.89 in interest and Sam earned only $18,487.15."

How I Pick Roth IRA Stocks

What am I looking for in stocks for a Roth IRA?

- I want proven, high quality companies who have been around a while and have a track record of paying and increasing their dividend, year after year.

- Stocks that have a history of outperforming the market (we will use the S&P 500).

- Companies that are producing significant amounts of free cash flow that they can then return to shareholders.

- My time horizon for this account is about 30 years, so there should be no doubt that these companies will still be operating by then. These should be companies who hold significant market share in their sector.

Top 5 Stocks

Without further ado, here are my top 5 stocks for a Roth IRA account.

Company Sector Market Cap (Billions) Yield
Realty Income Real Estate 7.94 5.4
McDonald's Restaurants 94.87 3.4
AT&T Communications 180.85 5.29
Coca-Cola Company Beverages 165.97 3.0
Altria Group Tobacco 69.49 5.54
Click to enlarge

Realty Income

Realty Income (NYSE:O) is a publicly traded real estate investment trust that trades on the NYSE. The company currently has a market cap of 7.94 billion with a share price of $40.46. The current yield is 5.4 percent.

Realty Income owns over 3,600 properties, diversified across 46 industries and 194 companies.

As of June 30, 2013, Realty Income's portfolio of freestanding, single-tenant properties consisted of 3,681 properties located in 49 states and Puerto Rico, leased to 194 commercial enterprises doing business in 46 industries. The properties are leased under long-term, net leases with a weighted average remaining lease term of approximately 11 years.

In terms of the highest percentage of lease revenue generated from the company's properties, distribution centers are number one, followed by health and fitness, drug store, and dollar store locations. Investment grade-rated tenants account for approximately 38% of our total rental revenue. (Source: RealtyIncome.com).

The Monthly Dividend Company

Realty Income is known as the monthly dividend company, and for good reason. The company has a 44-year history of "providing dependable monthly income" to shareholders. You will see from the chart below that Realty Income paid $.90 to shareholders for all of 1994. By 2013, that number is up to $2.10. This gives them a dividend growth rate of 42.1 percent since 1994.

Credit: RealtyIncome Corporate Presentation

With dividends re-invested, the company has provided shareholders with a 17.3 percent compounded average total return since 1994.

If you were to begin with $1,000 today and add just $100 to your investment in Realty Income each month, in 20 years your investment total would equal $119,190! Keep in mind that this assumes a 17.3 compounded annual average return, and past performance is not a guarantee of future performance.

Realty Income: Crushing the S&P

Besides outperforming their peers, Realty Income has outperformed the S&P 500 since 2000 by a great deal:

(click to enlarge)Credit: Yahoo!FinanceClick to enlarge

I like Realty Income because of their solid track record and history of paying dividends. If you want exposure to real estate in the stock market, I think this is the best REIT you can own for your ROTH.

McDonald's (NYSE:MCD)

McDonald's is obviously a company that needs little introduction as the company brand is ubiquitous across the world. Here is a brief overview of why I think this is a great stock for a Roth IRA.

- McDonald's has raised its dividend every single year since 1976, when it paid its first dividend.

The company has an amazing track record of dividend increases. Here is a chart below from the company's website, which shows incredible dividend growth during the period of 2000 to 2007. You'll see that the company went from paying just $.215 in dividends to $1.50.

Actual Dividend Amount Dividend Adjusted for Split Record Date Payable Date
1. 1.50 1.50 Nov 15, 2007 Dec 3, 2007
2. 1.00 1.00 Nov 15, 2006 Dec 1, 2006
3. 0.67 0.67 Nov 15, 2005 Dec 1, 2005
4. 0.55 0.55 Nov 15, 2004 Dec 1, 2004
5. 0.40 0.40 Nov 14, 2003 Dec 1, 2003
6. 0.235 0.235 Nov 15, 2002 Dec 2, 2002
7. 0.225 0.225 Nov 15, 2001 Dec 3, 2001
8. 0.215 0.215 Nov 15, 2000 Dec 1, 2000
Click to enlarge
Click to enlarge

Most recently, McDonald's declared a quarterly cash dividend of $0.81 per share of common stock payable on December 16, 2013, to shareholders of record at the close of business on December 2, 2013. This represents a 5% increase over the Company's previous quarterly dividend and brings the fourth quarter dividend payout to more than $800 million.

McDonald's also has a history of share repurchases.

- In 2011, the company bought back 41.9 million shares for a total of $3.37 billion.

- From the period of 2007 - 2011, McDonald's bought back a total of 276.8 million shares.

- If you were to buy just $1,000 worth of McDonald's stock in 1990, the value of your shares would be over $14,000 today. This does not include any other investment capital, just the original $1,000 investment. A $10,000 would be worth over $140,000.

Here is a look at McDonald's stock performance compared to the S&P 500:

(click to enlarge)Credit: Yahoo! FinanceClick to enlarge

While it is hard to say whether or not McDonald's will be able to keep up their amazing track record of dividend increases and share buybacks, I believe the company will at least keep outperforming the S&P 500.

In conclusion, I believe this is a company that will continue to return capital to its shareholders for years to come.

AT&T (NYSE:T)

AT&T provides telecommunications services to consumers, businesses, and other providers in the United States and internationally. The company trades under the symbol T on the NYSE.

AT&T is one stock on this list that actually hasn't outperformed the S&P 500, as you'll see on this chart below.

Credit: Yahoo! FinanceClick to enlarge

However, I believe the company is on the right track to outperform the market in the future.

- First, the company is focused on buying back shares to increase shareholder value. During the second quarter, the company completed its second 300 million share repurchase authorization; The company repurchased 89 million shares for $3.3 billion in the second quarter and the company has said they will continue to buy back shares "opportunistically" in the future.

- The company is focused on returning capital to shareholders via dividends as well. Here is a chart from the company website, which shows that the company has increased its dividends each year since 2003.

2013 11-01-13 10-10-13 $0.45
08-01-13 07-10-13 $0.45
05-01-13 04-10-13 $0.45
02-01-13 01-10-13 $0.45
2012 11-01-12 10-10-12 $0.44
08-01-12 07-10-12 $0.44
05-01-12 04-10-12 $0.44
02-01-12 01-10-12 $0.44
2011 11-01-11 10-10-11 $0.43
08-01-11 07-08-11 $0.43
05-02-11 04-08-11 $0.43
02-01-11 01-10-11 $0.43
2010 11-01-10 10-08-10 $0.42
08-02-10 07-09-10 $0.42
05-03-10 04-09-10 $0.42
02-01-10 01-08-10 $0.42
2009 11-02-09 10-09-09 $0.41
08-03-09 07-10-09 $0.41
05-01-09 04-09-09 $0.41
02-02-09 01-09-09 $0.41
2008 11-03-08 10-10-08 $0.40
08-01-08 07-10-08 $0.40
05-01-08 04-10-08 $0.40
02-01-08 01-10-08 $0.40
2007 11-01-07 10-10-07 $0.355
08-01-07 07-10-07 $0.355
05-01-07 04-10-07 $0.355
02-01-07 01-10-07 $0.355
2006 11-01-06 10-10-06 $0.3325
08-01-06 07-10-06 $0.3325
05-01-06 04-10-06 $0.3325
02-01-06 01-10-06 $0.3325
2005 11-01-05 10-10-05 $0.3225
08-01-05 07-08-05 $0.3225
05-02-05 04-08-05 $0.3225
02-01-05 01-10-05 $0.3225
2004 11-01-04 10-08-04 $0.3125
08-02-04 07-10-04 $0.3125
05-03-04 04-10-04 $0.3125
02-02-04 01-10-04 $0.3125
2003 11-03-03 10-10-03 $0.2825
Click to enlarge

- The company is growing its wireless subscriber base. For the last quarter, the company reported 551,000 wireless postpaid net adds, best second-quarter postpaid net adds in four years.

- Wireless revenues up 5.7 percent, service revenues up 4.1 percent versus the year-ago quarter.

- An increase in revenue is also leading to an increase in earnings, as the company reported second quarter 2013 net income of $3.8 billion or .71 cents a share, up from .66 cents a share in the previous year.

- Free cash flow, which is cash from operating activities minus capital expenditures, totaled $4.0 billion for the quarter.

In conclusion, I like AT&T because of their current dividend and long-term earnings prospects. I believe they will continue to return capital to shareholders in the form of dividends and share buybacks, and I believe this could be a stock that significantly outperforms the market for years to come.

The Coca-Cola Company (NYSE:KO)

Coca-Cola is a world-class company, to say the least. Some of the brands of Coca-Cola are among the most recognizable in the world. They include Sprite, Vitamin Water, Dasani water, Fanta, Simply Orange, Minute Maid and more.

I think Coca-Cola makes a great long-term stock selection for a few reasons.

- For one, the company seems very committed to maximizing long-term shareholder value. For example, between now and 2020, the company sees $400 billion in retail value growth in the developed and emerging markets. The company expects this to drive long-term EPS growth in the range of 10-plus percent.

- Coca-Cola increased its dividend 10 percent in 2013, paying out $5 billion to shareholders. The company current pays out a quarterly dividend of $.28 cents, giving the stock an annual yield of 2.9 percent. The payout ratio is about 57 percent, which shows it is sustainable.

Chart of Coca-Cola's Dividend History

This is a beautiful chart showing that Coca-Cola has increased its dividend year after year:

Credit: YCharts.comClick to enlarge

How is Coca-Cola able to return so much money to shareholders? Their operations provide a tremendous amount of free cash flow. In 2012, cash from operations totaled $11.5 billion, up from $9.5 billion in 2010, a compounded annual growth rate of 12 percent.

Long-Term Performance of Coca-Cola Stock

How has the stock fared against the S&P 500?

You will see that since 1980, KO has rewarded long-term shareholders with a gain of over 5,000 percent, much, much better than the S&P 500.

(click to enlarge)Credit: Yahoo! FinanceClick to enlarge

If you invested just $1,000 in 1980 and re-invested dividends, with no further investment added, your $1,000 would now be worth over $53,000.

I believe Coca-Cola will continue to treat shareholders nicely and I see them growing strongly over the next few years. The company has a long-term growth strategy in place and based on their past actions, it looks like they should continue returning money to shareholders for many years to come.

Altria Group (NYSE:MO)

Altria Group is the final stock I'd like to highlight here. Altria is the parent company for Philip Morris USA, U.S. Smokeless Tobacco Company and John Middleton. They operate a number of brands including Marlboro, Copenhagen, Skoal and Black &​ Mild.

Philip Morris USA has approximately half of the U.S. cigarette market share, led by Marlboro.

Altria group currently pays out $1.92 in dividends, giving the stock a yield of 5.53 percent. The company most recently increased its dividend in August, up 9.1% from the previous dividend.

The company has increased its dividend 47 times in the last 44 years.

In addition to the dividend increase, Altria announced a $700 million expansion of Altria's current April 2013 share repurchase program from $300 million to $1 billion. Altria expects to complete the program by the end of the third quarter of 2014, according to the company.

You'll see from this chart below that Altria has outperformed the S&P 500 since inception:

(click to enlarge)Credit: Yahoo! FinanceClick to enlarge

From 2008 to 2012, Altria's total shareholder return was 84.2 percent, outperforming the S&P 500's return of 8.6 percent over the same period, according to the company website.

A $1,000 investment in Altria in 1990 would now be worth $9,407, a gain of about 840 percent.

Due to Altria's market share in the tobacco industry and their ability to generate substantial amounts of cash flow to return to shareholders, I think Altria will continue to outperform the market for many years to come.

Final Thoughts

An investment in a high quality stock like any of these five can result in some pretty amazing gains over time. Most of these stocks have outperformed their peers and the market for a number of reasons. I believe when management focuses on returning capital to shareholders via dividends and buybacks, shareholders are rewarded and this leads to outperformance.

Even if you disagree with my selections, everyone should agree that starting to invest as early as you can is the best thing you can do.

Do you agree with this list? What other stocks should have been selected? Please comment below.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.