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By Mark Bern, CPA CFA

<< Click to view Part 1

In the first article I discussed why I thought a portfolio that stressed both income and capital preservation would be beneficial in light of the current potential black swan of Europe circling the global economy. As review, I just want to make clear that when I speak of capital preservation I am not attempting to build a portfolio that will completely eliminate temporary losses. How I define capital preservation is to hold investments that may fall in a crash, but not as much as the overall market, and that will regain their value as a group before the rest of the market has completely recovered.

By virtue of companies being able to increase earnings even through difficult economic times, I conclude that the value remains intact as long as the investor does not sell shares and lock in losses. My preference is for dividend-paying equities with a commitment and history of regularly increasing dividends at a pace that exceeds inflation.

Holding cash in a savings account does not necessarily preserve the purchasing power since inflation in the current interest rate environment is likely to rise faster than the earnings, thus creating a loss in purchasing power. Nominal capital may be preserved, but not the real value of the capital.

The first four equities and their respective industries were:

Procter & Gamble (NYSE:PG) Household Products

Johnson & Johnson (NYSE:JNJ) Medical Supplies

Wal-Mart (NYSE:WMT) Retail, General

El Paso Pipeline (NYSE:EPB) Pipelines

Also in the first article I said I would explain how to invest a portion of a portfolio in investments denominated in other than U.S. currencies. Of course, you may simply purchase American Depository Receipts or ADRs to capture the impact of foreign exchange differences. Also, many large U.S.-based companies have global operations and can provide much of the benefits from a falling U.S. dollar.

However, you need to choose carefully among the ADRs, most of which fall into two categories. Most ADRs represent companies in developed countries around the world, many of which are in Europe. If we're trying to avoid the perils of Europe it wouldn't make sense to buy ADRs for European companies. Of the remaining ADRs many are for companies from emerging economies where the accounting methods are questionable. That leaves us with a few ADRs from a few countries.

There is nothing wrong with taking this route, but I believe there may be a better way. So, that doesn't count. On the other hand, I do not profess to be the expert in this particular area of investing so the alternatives that I offer may not be among the best options available. I will put them out there for review and consideration but I would also like readers with more experience in this area to share their options and experiences or links to articles that could shed better light on the topic.

Some of the emerging nations' debt is more likely to appreciate relative to the U.S. dollar because of the much more favorable debt to GDP ratios and continuing robust economic growth. Interest rates are already relatively high to combat inflation in many of these nations and are likely to decrease if global growth were to slow significantly. That would translate into larger gains.

There are several ways to approach this type of investing. The first and most often used is to buy shares of a mutual fund. Unless the fund is a no-load fund with very low expenses I would not consider it. Also, there are few funds that I am aware of that do not also include some developed country debt. Another way is to use an EFT invests in foreign debt issues. One that may fulfill the need is the Wisdom Tree Emerging Markets Local Debt ETF. The problem is that it does not allow the investor to take advantage of the select few developed countries' debt that may also provide good appreciation opportunity.

Another method is to locate a bank that allows you to purchase certificates of deposit denominated in foreign currencies of your choice. The yields are generally higher and you have the potential for foreign exchange gains as well. EverBank offers this service and I suspect you can find others located in the U.S. that would do the same. Some of my favorite countries to park money in are Australia and South Africa. However, the inflation rate in South Africa has been around 6% lately and CDs only return 3.5%. In Australia, the CDs return up to 2.75% but inflation is currently running at about 3.1%. There just doesn't seem to be any easy way to lock in good returns overseas these days. I realize that this section isn't very helpful or straight-forward. I found it frustrating as well while doing my research for this article. But, from where I sit this may bring me back to a few carefully selected ADRs for the best potential results.

So, let's get back to the conservative equities portion of the article with my four new offerings. My first selection is American Water Works (NYSE:AWK), the largest publicly traded water utility in the U.S. There are other companies in the sector that offer slightly better yields, but AWK is more than three times the size of its nearest publicly traded competitor, and yet its annual revenue remains below $3 billion. This is a very fragmented industry with most operations run by local governments. I like the size of AWK, along with its track record, because this remains an area ripe for further consolidation, especially with local governments facing budget shortfalls.

As the population grows, demand for clean water continues to increase. Many areas are experiencing depletion of ground water and others are suffering from droughts. The value of clean water will continue to rise over time as the limited supply becomes more stretched by relentlessly increasing demand. The current dividend yield is 2.8%, and it has risen in each of the four years since the dividend was started. For a more detailed report on AWK, please see my recent focus article. Earnings have grown consistently since 2007, counter to the direction of general economy.

Year

2007

2008

2009

2010

2011

EPS

($2.14)

$1.10

$1.25

$1.53

$1.78*

Div. / Share

-

$0.40

$0.82

$0.86

$0.91

*Estimated

The next equity offering, McDonald's Corp. (NYSE:MCD), has a brand recognized the world over. It has over 33,000 fast-food restaurants globally, and derives 66% of revenues from outside the U.S. The company is growing its number of outlets rapidly in China with about 2,000 outlets there in 2011 and expectations of doubling that number by 2015.

Even though the economy remains sluggish and unemployment high, the company continues to post record sales and profits. People who are in the habit of eating out but find themselves with reduced incomes are migrating to McDonald's. The longer the economy remains stagnant, the more entrenched habits may become. Same store sales reported in the most recent quarter were up 7.5% worldwide and even 7.3% in Europe. Total revenue increased by 10% during the quarter over the same period a year ago.

The current dividend is 2.8%. The dividend has increased in every year for 35 consecutive years increased in each of the last nine years, dipping only slightly during the 2001-02 recession. The share price dropped only 17% from peak to trough during the last recession while the S&P 500 index fell 57%. The share price has gotten a little ahead of the overall trend, so investors should probably wait for a dip to find a better entry point.

Year

2006

2007

2008

2009

2010

2011

EPS

$2.30

$2.91

$3.67

$#.98

$4.60

$5.27

Div. / Share

$1.00

$1.50

$1.63

$2.05

$2.26

$2.53

My third equity offering of this article is Verizon (NYSE:VZ). I went back and forth between VZ and AT&T (NYSE:T) but two factors tilted the scale toward VZ. The first is the error in judgment that T management made in its ill-advised attempt to purchase T-Mobile that ended up costing the company $4 billion. The second factor is the sizable gap in new subscribers attracted by each company in the most recently reported quarters. VZ added 1.5 million new subscribers during the last quarter. The most recently reported quarter for T included 300,000 new subscribers. T's number was from the quarter ended September 2011 while VZ's number came from the December quarter, so the likelihood is that T's number for the same quarter will be higher, but I doubt if it will reach anything close to 1.5 million.

T has the better dividend record for increases, but the VZ stock price represents a better value at the moment in my estimation. VZ pays a dividend yielding 5.2% and it has increased the dividend in each of the last six years. Earnings per share have not been rising consistently nor have earnings been trampled by the recession. The company is in the middle of a heavy capital expenditure program (actually, more than one; FIOS for wire line business and 4G LTE for wireless) which is holding earnings down temporarily. Also, the high cost of acquiring new iPhone users is taking a chunk out of margins. However, all of these items are temporary and each is increasing earnings capacity for future periods. This is a stability and income play that should increase the overall yield of the portfolio.

Year

2006

2007

2008

2009

2010

2011

EPS

$2.54

$2.34

$2.54

$2.40

$2.20

$2.16

Div. / Share

$1.62

$1.65

$1.78

$1.87

$1.93

$1.96

My final equity offering for this article is PepsiCo (NYSE:PEP), one of the largest beverage and food manufacturers in the world. Coca Cola (NYSE:KO) was another company in this sector that I considered, but due to its in large cash hoard overseas that cannot be repatriated without paying U.S. income taxes; the company's record of increasing the dividend may be in jeopardy. (Stephen Rosenman wrote a great article outlining this problem.) Thus, I stuck with my favorite company in the sector and one of my favorites overall. Once again we have a company with a sterling EPS and rising dividend record. The company hardly skipped a beat during the recession and has increased the dividend for 39 consecutive years. The dividend currently yields 3.1%.

Year

2006

2007

2008

2009

2010

2011

EPS

$3.00

$3.34

$3.21

$3.77

$3.91

$4.30*

Div. / Share

$1.16

$1.43

$1.60

$1.75

$1.89

$1.99

*Estimated

You can also find links to more detailed focus articles on many of the companies I am highlighting in this series here.

>> Click to view Part 3


Disclosure: I am long PEP, PG, JNJ, T, MCD. I am considering adding AWK, WMT and EPB to my portfolio over the next few weeks.

Source: Building A Capital Preservation And Income Portfolio, Part 2