The Perfect Portfolio, Evolved

by: Ry The Kid

The last article I wrote received many positive yet mixed reviews, and some readers viewed some holdings are redundant in certain sectors. Many constructive comments were made, and the one that stuck with me was that a truly great portfolio is one that evolves with time. Comments were also made about being overly conservative by only buying near 52-week lows, which some companies rarely hit. I would still like to only buy stock in a company if it is trading below the midpoint of its 52-week range, but that is not a deal breaker for me anymore. However, I stand by my philosophy that being truly diversified doesn't mean owning companies from every sector in the market. I still think some sectors can be omitted, while maintaining diversity and the portfolio's overall goal, a rising income stream. This can be achieved while maintaining a low beta, a healthy payout ratio, and owning the best-of-breed companies. I have decided it would be better to include industrials and utilities to the portfolio. However, I still do not feel the need for a healthcare conglomerate, bank, or tech company, and all are omitted for the reasons below.

Healthcare: This is a very important category, but do you know who is going to cure diabetes? AIDS? Cancer? A breakthrough for one company could mean the downfall of another, and since I have no medical knowledge to speak of, why risk it? Pfizer (NYSE:PFE) cut its dividend in last crisis, Johnson & Johnson (NYSE:JNJ) has thousands of claims against it at potentially $3M each for its vaginal mesh disaster, and the hip replacements are frightening as well. I can tolerate recalls of McNeil products such as Tylenol and Motrin, but recalling medical devices already surgically implanted in someone's body sounds rather expensive and negligent.

Banks: Banking is very profitable if done correctly, but it seems banks play by their own rules and have little transparency and accountability. Also it seems most banks dilute their float regularly, when I will only buy companies that do the opposite. JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), and Citigroup (NYSE:C) have all increased float by over 40% in the last decade, with Chase nearly doubling its share count and Citigroup embarrassingly has 6x more shares than it had 10 years ago. Now these companies want to buy back shares, at inflated prices. Wells Fargo, the least dilutive bank of the group, would have to spend a whopping $66 billion at $35 to just get back to the same share count it had 10 years ago (from 3.4B in 2002, to 5.35B today). It's insane to wake up after a decade of dilution and say it's in the best interest of shareholders to buy back stock. So sorry banks, no room in the portfolio for you. Regional banks have a better history, but I want large-cap stable companies in my portfolio, and most banks aren't big enough to make the cut.

Tech: Technology is an ever-evolving industry with no clear view of what anything will look like in 5 years' time. I remember in high school, when I looked something up, it was on, and then was the best search engine, and now Google is. Yahoo has gone from hero to zero, and nobody asks Jeeves anything anymore. To further my point, Intel (NASDAQ:INTC) is a great company that I have recently owned. My smartest relative is employed by them and I truly believe they will be around in 15-20 years. I would love to know why Intel, with their terrific earnings, dividend yield, payout ratio and margins, is down over 25% in the last year; while Hewlett-Packard (NYSE:HPQ) has negative earnings and is up 30% YTD. If it's because of the $8.8B write-down recently, maybe they should have looked more carefully, as $8.8B write-down on a company with a $42B market cap is quite a large number. Even Exxon Mobil would be hurt by a write-down that large and they are 10x the size of HPQ. I don't understand technology well enough to invest comfortably in the sector, and I don't know what the next tech boom will look like, what it will be, or who will make it. Many tech companies are extremely profitable; however, many are not, and I am not savvy enough to be able to pick the future winners from the losers. Some companies are easy to own from a psychological standpoint, and some companies have me checking the news everyday to see how they are doing. Unfortunately Intel is the latter. I couldn't sleep at night owning a tech company, and that's the one metric you cannot account for at the time of your purchase.

So without further ado, the PERFECT portfolio is...:

The following are additions to the portfolio:

Diageo PLC (NYSE:DEO) - consumer goods - alcohol, increased yearly dividends since they were initiated in 2000, and they have many brands in their portfolio that you can find in nearly every home and bar in America. The most popular brands they own are Johnnie Walker, Crown Royal, Captain Morgan, Smirnoff, Ketel One, Ciroc, Bailey's, Tanqueray, Guiness, and they own the distribution rights to Jose Cuervo (however talks to buy Cuervo outright have failed). They have decreased share count by over 20% in the last decade, and have had an average return on equity of over 40% for the last 7 years. This company performs well in good times and bad, for example, did you stop drinking alcohol during the last recession? I may not have gone out to the bars as much, but there aren't many times when I can say that I didn't have a bottle of Captain Morgan in my freezer. Economy goes up and people are happy and they drink, economy goes down and people are sad and they still drink. Win win.

Caterpillar (NYSE:CAT) - industrial goods, they will have a record of 20 years of increasing dividends this June. While their share count has only gone down slightly (5%) in the last 10 years, book value has tripled so they have earned a spot in the portfolio. The world's population is growing, meaning we need more infrastructures such as roads, houses, factories, bridges, subsurface minerals, etc., and Caterpillar is ready to help the world out. They hit their goal of $50B in earnings by 2009, and they expect future earnings to go from $65B this year to $100B by 2020. The CEO said, "we're the Coca-Cola of the manufacturing world. We're No.1 or No.2 on virtually every continent." I don't see any reason why the CEO would miss on the most recent prediction. Even during the recession when Caterpillar was at a standstill, they elected to increase the dividend to let shareholders know what the company is all about.

Exelon (NYSE:EXC) - utility, cut forward dividends significantly and many long-term shareholders have lost a lot of money over the last several years owning this stock. This had something to do with management, tanking natural gas prices, and stagnant earnings. However, I believe the stock had been overvalued for quite some time, and has just settled back to reality and shareholders are in a good position going forward. Revenues are up, and shareholders can see the light at the end of the tunnel. The shares are finally trading pretty close to book value, and book value on a fleet of nuclear power plants is pretty significant. Nuclear energy is the greatest and cleanest energy source in the history of the world, and going forward into the next few generations I think we will see many fossil fuel plants convert to nuclear energy or become obsolete. While previous shareholders have been pretty badly bruised, I believe going forward into the next decade Exelon will once again be a shining star from a dividend and clean energy perspective.

Union Pacific (NYSE:UNP) - domestic railways, has more than tripled its dividend over the last 15 years, INCLUDING the dividend cut many railroad companies made at the beginning of the century. Earnings have been exploding lately, and are expected to increase at >15% for at least the next 5 years. Share count is down roughly 20% in the last decade and I expect this trend to continue. Good margins, earnings and an economic moat make this a good dividend stock to own. As with Caterpillar, the world is constantly building and destroying, and moving all the materials long distances is over three times more expensive by truck than by rail. While UNP doesn't have overseas operations, global trade requires freight to be taken from the U.S. port cities inland, and vice versa. Railroads built America, and they continue to keep it strong and running. I don't see any reason why railroads will not be in America for the next 100 years.

Becton, Dickinson and Co. (NYSE:BDX) - healthcare supplies, 40+ years of annual dividend increases and they still only have a 33% payout ratio. They have bought back nearly 30% of outstanding shares over the last decade and averaged well above 20% return on equity during that time. Earnings and margins are on the rise, and 15% free cash flow is a wonderful thing to have. Probably every hospital and clinic in the country has syringes or other products from BDX in the stockroom. My wife is in healthcare and her clinic orders BDX syringes by the truckload, and frequently. As the world gets older, and as more people are becoming diabetic and unhealthy daily, the need for needles has never been greater. BDX is a name hospitals and patients have trusted for many years, and I don't see why this would change. Almost all Americans (and those worldwide with access to healthcare) receive multiple injections a year between flu shots, inoculations and doctor visits, and the beautiful part is needles can only be used once. Billions of syringes are NEEDED every year, and BDX has cornered the market. The next time you get a shot, it will most likely be a BDX syringe.

Unchanged in the portfolio are the following: Click here to read the last article as to why these have been included.

Coca-Cola (NYSE:KO)

McDonald's (NYSE:MCD)

Chevron (NYSE:CVX)

Wal-Mart (NYSE:WMT)

Philip Morris (NYSE:PM)

Exxon Mobil (NYSE:XOM)

Visa (NYSE:V)

MasterCard (NYSE:MA)

I know I have an overlap in credit cards, but the idea of getting a small cut of every transaction someone makes, and all Visa or MasterCard had to do was supply some plastic and a magnet, seems like a wonderful tradeoff. I like American Express (NYSE:AXP) as well but I don't think I need three card companies. Maybe I could switch out MasterCard or Visa for American Express.

Removed from the portfolio: Target (NYSE:TGT) was omitted only to slim down the portfolio and avoid redundancy in discount variety stores. The reasons for its original inclusion is found in my last article.

All of the companies above (except EXC) have dividend charts that look like "steps" gaining momentum each year. Most of these companies are expected to increase revenues and earnings at more than 10% yearly, leaving ample room for dividend growth. Every company has an overseas presence (except UNP) and growing. This is my "wishlist" portfolio as a married 25-year old with children, and it is the same portfolio I would recommend to my 80-year old grandmother, my 17-year old cousin, and anyone in between. The best companies in the business, coupled with a low beta and increasing earnings and dividends, make this a winning portfolio for anyone.

This portfolio has been expanded and revised with helpful comments from the Seeking Alpha community. I know this portfolio will evolve over time, but currently I think anyone would be hard-pressed to find a list of companies with wide economic moats, rising revenues earnings and dividends, and still be able to get a good night's sleep. If there are any switches, omissions, arguments or comments I would love to hear them.

Disclosure: I am long MCD, PM, KO. 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.