Building a Model Income Portfolio Sector by Sector: Part 1 - Consumer Discretionary

Includes: GPC, MCD, MDP, STRA, TGT
by: Clay King

Over the next several weeks I will examine each of the ten economic sectors of the S&P 500 and suggest certain dividend stocks in order to build a "model" portfolio. Our goal is not to track the index but to build into our income portfolio some of the benefits of a diversified strategy. By incorporating each of the general levels of our economy into a portfolio, risk is reduced as each sector will rise and fall in varying percentages. Of course, the overall parts of any portfolio invested entirely in equities will rise and fall with the general market. Each article will add a sector until we have completed our model portfolio. The stocks selected in each sector are not meant to be "buys" at the time of selection, but certainly viable candidates for purchase.

Consumer discretionary will be our first sector. The aim is to screen and suggest a short list of high quality stocks for each sector. The database used for the screen is the 1500 stocks that make up the S&P 500 index, the 500 stocks of the mid-cap index, and the 600 stocks in the small-cap index.

the construction of a portfolio it is common to use the sector diversification of the S&P 500 composition as a guide. Most institutional money managers' portfolios will maintain positions in each of the economic sectors that comprise the index. The sectors and current weightings are:

Consumer Discretionary 10.67%
Consumer Staples 10.7%
Energy 12.6%
Financial 15.0%
Heath Care 11.9%
Industrials 11.2%
Information Technology 17.7%
Materials 3.6%
Utilities 3.4%
Telecom Services 3.1%

Consumer discretionary represents that part of the economy that includes businesses that sell nonessential goods and services. Types of companies include, retailers, consumer services, media, autos, consumer durables and apparel.

We began our search for income producing stocks in this area by screening the sector for yields above 2.5%, a five year dividend growth rate above 5%, and a payout ratio less than 60%. This criteria produced 16 stocks which we further reduced by eliminating those that had not increased the dividend each year for the previous five years. Five securities remained, which are outlined in the table below.

Security Yield Payout Ratio Div. Growth Rate Past 5 Yrs. Est. Div. Future Growth Rate Est. Earnings Growth Rate 3-5 Yrs.
Genuine Parts (NYSE:GPC) 3.3 65% 5% 5% 11%
McDonald's (NYSE:MCD) 3% 50% 19% 9% 9%
Meredith (NYSE:MDP) 3.3% 35% 9% 9% 12%
Strayer Education (NASDAQ:STRA) 3.3% 38% 33% 0% 13%
Target (NYSE:TGT) 2.6% 26% 18% 6% 12%

Depending on the desires of the individual investor the portfolio can be over or under weighted from the 10.7% used in the S&P 500 Index. In order to achieve the benefits of a balanced portfolio, a weighting of 50-150% of each sector is suggested. The diversity within each sector allows the investor latitude in using industry groups within the sectors to further broaden equity selections. For instance, if one is bearish on bank stocks, then adding insurance companies can offer a counter weight while still maintaining a commitment to financial stocks. The number of stocks selected in each sector will depend on the concentration each investor wishes to utilize. Personally, I would use 2-4 stocks if I'm equally weighing this sector. At this time I am underweighted with only a single position in McDonald's. The average yield of the sector is 3% using these 5 stocks.

Part 2 will be consumer staples when we continue the building of our sample model portfolio across all economic sectors.

Disclosure: I am long MCD.