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Retirees can take a proactive approach to their portfolios in "frothy" markets

The market has recovered from the recent correction and again is near its all-time high. Although not impossible, it is becoming more and more difficult to find bargain securities. For retirees living off dividends, this is a twofold problem.

Firstly and obviously, there is a risk of a portfolio value decrease should a correction or even a bear market occur. To a retiree who is simply cashing dividend checks, this may not matter, so long as companies do not cancel or cut their dividends. Yet if a large sum of money becomes necessary, such as for a major purchase or an unforeseen medical or legal expense, the overall portfolio value may become important since a retiree may have to sell some stock to finance such an expense.

Secondly, frothy market limits reinvestment of any unspent dividend (or any other) income. Buying overvalued or even fully valued securities is not the best use of capital.

Fortunately, there are several things a retiree can do to better position the portfolio during a high-flying market.

Stockpiling cash

This is straightforward: if there isn't anything to invest in, don't invest in anything. Excess dividend proceeds can simply wait for an opportunity to buy attractively priced securities. However, if there are no excess funds, there are still options on the table.

Selling expensive securities to buy less expensive ones

Sometimes recycling your capital may be appropriate. When the stock market is flying high, most securities are expensive, but some are (sometimes significantly) more expensive than others. For example, Lockheed Martin (NYSE:LMT) presently trades for 18 times earnings, whereas General Dynamics (NYSE:GD) sells for just over 15 times earnings. There are other valuation metrics than the P/E ratio, but the point remains: if you think that the fundamentals of both companies are similar and by your preferred valuation metrics, one is less expensive than the other, you can consider shifting some of the capital into a less expensive security. In our example, both securities are conveniently in the aerospace and defense business and a swap would not change sector allocation. If the change happens within a retirement account, capital gains taxes conveniently remain a non-issue. Please notice that we are not considering dividend yield in this particular example.

Selling lower yielding securities to buy higher yielding ones

Another form of recycling capital is to sell securities that ran up so much as to become very low yielding. Becton Dickinson (NYSE:BDX) is an example of such a security: even after a recent 10% dividend increase, it still yields less than 2% at the time of this writing. Becton Dickinson also happens to trade at about 24 times earnings. Baxter International (NYSE:BAX) yields a more respectable 2.8% - a noticeable difference. Baxter also trades at just under 19 times earnings, so if we swap Becton for Baxter, we are getting both the higher dividend yield as well as higher earnings yield. If you think that the business prospects are similar for Becton Dickinson and Baxter, you can swap the former for the latter and enjoy a higher dividend yield.

Running to quality

Say you have a few speculative stocks in your portfolio (no examples, but investors usually know when they have these). You can cushion your portfolio against potential correction or bear market losses by shifting the funds in your portfolio towards non-overpriced, high quality companies. Here are some examples.

Zurich Insurance Group Ltd (OTCQX:ZURVY) is a Switzerland-based holding company engaged in the insurance sector. The Company provides a range of general and life insurance products and services for individuals, small business, mid-sized and large-sized companies, and multinational corporations. The company stock has underperformed the market somewhat and is trading at just under 11 times earnings and just under 1.4 times book value; it presently yields about 6% and the dividend appears well-covered with a payout ratio of just under 70%. The company business operating profit showed a 15% year-over-year increase for 2013 and the company showed disciplined underwriting with a combined ratio of 95.5% in 2013, down (lower is better) from 98.4% in 2012. The dividend is paid once a year.

PepsiCo (NYSE:PEP) is a global food and beverage company. Through the Company's bottlers, contract manufacturers and other partners, it makes, markets, sells and distributes a range of foods and beverages in more than 200 countries and territories. The company beat earnings projections by $0.04/share, grew organic snack and beverage volumes, just raised its dividend payout rate to $2.62/share from $2.27/share (a 15% increase!) and also raised its share buyback authorization to about $5 Billion. Yet, the stock is down nearly 4% in the last 2 trading days, likely related to unwillingness to spin off the beverage business and a slight revenue miss. Given the new dividend yield of over 3.3% and a not too unreasonable valuation of about 18 times earnings, this is a reasonable high-quality addition to almost any retirement portfolio.

Disclosure: I am long GD, LMT, ZURVY, PEP, BAX, BDX. 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.

Source: Portfolio Management For Retirees: Frothy Market