A laddered portfolio of bonds was all it used to take for a nearly risk-free stream of income in retirement. Rates in the high single digits for long-term investment grade debt were the norm and inflation was stable. While rates have come off their historic low, even strong corporate debt isn't going to yield much after inflation and that is if you are able to hold them to maturity. Bonds will surely see a tough pricing environment as rates increase over the next few years and retirees need to look to dividend stocks for income opportunities.
The usual suspects of utilities and REITs are underperforming as rates creep higher and do not provide the growth that is needed for many that have seen their portfolios melt in the market crashes of recent memory. The average balance for people 65 and older in Vanguard Funds is just $176,696 and will not be enough to replace current income in retirement. Assuming you collected the $1,246 average for social security monthly and were able to cut expenses to just a third, a person making the median personal income of $50,000 a year would need a return of 10% on this level of savings.
That's a far cry from about 4% on investment-grade corporates and even the higher yield on junk bonds. While you may still have to adjust your plans for retirement, the market does opportunities to take advantage of the long-term growth in stocks as well as a stable stream of income.
Keep it simple
Safety is still extremely important in retirement investing, even if you have to reach for higher yields. I have found that a lot of people think that their investing strategies have to get more complicated as they look for higher rates of growth and dividends. This could not be further from the truth.
The best companies with the strongest long-term prospects usually have three things in common.
- A wide economic moat of industry leadership with barriers to competition
- Consistent free cash flows even as the company consistently increases capital spending
- An aggressive stock buyback and dividend policy that limits pet-projects and overspending
As with any smart portfolio of stocks, you need to spread your investments over several industries and sectors. This will help avoid a big drop in portfolio value due to any negative headlines within a specific group.
Three strong choices to start
Unilever (NYSE:UN) is one of the largest providers of consumer staple goods in the world with a strong presence in emerging markets and Europe. The company was among the first to target emerging markets and has a strong identity for many of its brands. The scale of the company gives it bargaining power over retailers.
Shares have come down from highs set in April of last year on an economic slowdown in emerging markets that could last years according to CEO Paul Polman. While the slowing rate of growth in developing nations is a theme weighing on many of these international names, a growing middle class in these parts of the world is still going to boost growth over the longer-term. I think the lower growth is already built into share prices and a rebounding Europe and stronger growth in the United States could spill over into other parts of the world.
Though the company has not bought back shares over the last several years, it has increased its annual spending for dividends by a compound rate of 6.8% over the last three years. Capital spending has jumped 70% from 2009 as the company positions for even stronger growth in key markets. Growth of free cash flow has weakened on the higher capex budget but still managed a 4.3% compound rate over the longer term and could jump higher when spending comes down.
Shares are relatively cheap at 17.5 times trailing earnings and pay a 3.2% yield.
Merck & Company (NYSE:MRK) is one of the largest pharmaceutical companies in the world with a market capitalization of $137 billion. The company is diversified across a range of solutions including prescription medicines, vaccines, biologic therapies, animal health and consumer care. Biotech has taken the healthcare spotlight over the last few years but it is these large-cap pharmaceutical companies that will benefit most from an aging demographic over the next decade.
Merck is already a cash machine with $8 billion in free cash flow over the last fiscal year (2012). Though free cash flow was down last year, the five year average is an impressive 6.1% annualized growth even in the face of increasing capital expenditures by 10% a year in the last three. The company has consistently returned money in the form of a buyback and dividends and bought back $7.4 billion in shares over the last four quarters.
While shares may look expensive at 33.2 times trailing earnings, they are still relatively lower than the 42.1 times 5-year average multiple and pay a 3.5% yield.
Cisco Systems (NASDAQ:CSCO) is the king of networking and even though some may question this accolade given a slowdown in hardware, the company is positioned to take advantage of the shift to services and cloud computing. Technology stocks have just recently become dividend payers and still offer growth upside on technological breakthroughs.
Cisco also warned investors late last year that sales would be lower on slowing emerging market growth. CFO Calderoni told analysts that revenue growth would be between 3% and 6% over the next several years. Again, I think the market is swinging to overly conservative on emerging markets after being too optimistic in the last few years. Faster adoption of internet usage and networking in these markets could drive upside surprises on sales growth over the coming years.
The company spent $14.4 billion to buyback shares over the last three years and paid out $3.3 billion in dividends last year alone. Capital spending has increased fairly consistently over the last few years but hasn't slowed a strong 8.5% compound annual increase in free cash flows.
Given a strong cash flow position and still high possibilities for growth, shares look very cheap at 12.0 times trailing earnings and pay a 3.1% yield.
Outperforming on a risk-adjusted basis
The safest dividend stocks, like those above, may not always outperform the market on an absolute basis but you will also not see the volatility in prices that you see in other stocks. Their size and cash flow power gives them breathing room when the economy tanks or when opportunities come along to buy up cheaper assets.
The three companies above have strong business models with competitive advantages in their industry and a history of returning cash flow to shareholders. As equity ownership, they should provide some inflation-protection and help retirees boost their income stream with capital gains.
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.