In Developing A Diversified Portfolio For Income: 5 Stocks To Consider And 1 To Avoid

 |  Includes: COP, LLY, MCD, PG, T, UTX
by: Mark Bern, CFA

By Mark Bern

When an investor is developing an equity portfolio with a focus on income they should take care to select companies that have characteristics that make them suitable for the investor. Like me, many investors want income with some growth and don't want to trade a lot to achieve those goals. Here are some characteristic I look for in companies to fulfill those goals:

- The companies should have a sustainable advantage over competitors or a significant barrier to entry to keep competitors at bay.

- The companies should demonstrate sustained growth capabilities that extend well into the future.

- The companies should demonstrate a commitment to increasing dividends to keep my portfolio income ahead of inflation.

Those are my three commandments of investing for income. I have listed within this article five stocks that I own personally that meet those criteria. I also listed one stock that does not meet the criteria with an explanation of why it does not.

I differentiate these stocks based upon my expected average total return over the next five years. Five have very favorable outlooks by my estimates while the other one could see the respective stock prices fall from current levels. I have written more detailed focus articles on most of the stocks over the last three months and links to those articles can be found here, should readers want to dig a little deeper into one or more of the companies on this list.

Procter & Gamble (NYSE:PG) is one of my all-time favorite companies. I own PG stock primarily because the company pays a nice dividend yielding 3.2% currently and has raised its dividend every year for 55 consecutive years. The company produces and sells 250 under different brands in more than 180 countries around the globe. It is highly probably that everyone reading this article uses at least some of PG's products in their home regularly. The majority of its products are made to be used over a short time (some only once), disposed of and replaced on a regular basis. We're talking toilet paper, soap, toothpaste, detergents, make-up, cleansers, razors, etc. Nobody stops buying toilet paper (I hope). The company has become very adroit at creating and developing brand value and loyalty through its marketing prowess. The company uses differentiation to create that value and to sustain its business model. My estimated average annual total return over the next five years is 12%.

United Technologies (NYSE:UTX) is another of my favorites because it is so well positioned to take advantage of the growth in emerging markets. It is a global diversified company offering a variety of products and services through its six business units: Carrier HVAC equipment and services; Hamilton Sundstrand aerospace and industrial systems; Otis elevators and escalators; Pratt Whitney aircraft engines; Sikorsky helicopters and UTC Fire & Security surveillance and fire monitor systems. The UTC unit is also a leader in fuel cell development. I own UTX because much of the infrastructure that is being built in emerging markets uses UTX systems and then the new owners sign long-term service contracts for maintenance, again with UTX. UTX's current dividend yield is 2.6% and the dividend has been increased every year for the past 17 years. The company has been able to build and sustain its growth while competitors have stumbled. I am not sure how to describe the sustainability of its business model other than to say that the company has demonstrated its superior management even through difficult times. My estimated average annual total return over the next five years is 15%.

AT&T (NYSE:T) is another company I like because of its defensive nature and that is why I own T stock. Americans have become more and more dependent upon mobile phones, especially those iPhones. AT&T continues to sign up new subscribers at a rate of 300,000 per quarter. But that's not the biggest plus; traditional cell phone users are upgrading to smart phones at an increasing pace and are willing to pay an average of 40% more per month for the privilege. And where does most of that 40% more go? Watch the bottom line. This isn't a sexy, high growth company. It's a steady, consistent growth company that has raised its dividend every year for the last 26 consecutive years. The company has been able to demonstrate its ability to evolve with the technology of its industry and has developed a dominant position in the U.S. communications industry. It's been here since long before our great grandparents were born and it will still be here to sell communications services to our great grandchildren. My estimated average annual total return over the next five years is 11%.

ConocoPhillips (NYSE:COP) is one of my favorite companies in the oil patch. I own COP stock even though I'd rather that the company not be broken up into an exploration/production company and a refining/distribution, marketing company, but I didn't own enough shares to sway the vote. I do expect that shareholders will end up with an initial boost to both share values and dividends in the first year. That is one of the reasons I included it in this article. The current dividend yield is 3.6% and the dividend has increased in every year for the last 11 years. Management has indicated that the two dividends paid by the new companies are likely to total more than what we current receive. The company has significant reserves and has proven its ability to replace assets in the ground through its exploration efforts. It has a sustainable business model as long as humans still use oil products. And, in my opinion, it has excellent management. My estimated average annual total return over the next five years is 12%.

MacDonald's (NYSE:MCD) needs no introduction. It's the largest, most recognized fast-food chain in the world. The company is growing rapidly in emerging markets, especially in China. The U.S. market is already saturated as evidenced by driving down any Interstate and watching the signs for eating establishments. It remains the cash cow providing capital for investment wherever else growth prospects still exist; and there is still an abundance of places to grow. The company has demonstrated that it can adjust its menus and service models to fit nearly any culture in the world and thus, I expect the company to continue its expansion until the rest of the world looks like the U.S. in terms of geographic saturation. And that will take many decades. The current dividend yield is 2.8% and the company has increased the dividend in every year for 35 consecutive years. The stock has gotten a little ahead of itself so I'd wait for a pull back into the lower $90s range, but from there I estimate the average annual total return over the next five years is 10%.

Eli Lilly (NYSE:LLY) is a large pharmaceutical company with a global footprint. Patent expirations are the major concern as its largest product, Zyprexa lost patent protection in October of last year (2011). The company will also lose patent protection and face generic competition on several other major drugs over the next several years. I believe the pipeline will eventually provide the sales needed to turn revenue prospects from declining to growing again. But that will take some time and the shares could see more downside pressure in the meantime. The current yield is a fat 4.9% but as a result of the patent protection losses dividends are no longer rising. The company has lost its ability to sustain its growth through a lack of regular new innovations flowing through its R&D pipeline. My estimated average annual total return over the next five years is 3%. If you hadn't noticed, that's less than the dividend.

Disclosure: I am long PG, UTX, T, COP, MCD.