A High-Yielding Income Portfolio Based On 6 Stocks With An Average Yield Of 6.5%

Summary

• A simple income and dividend reinvestment portfolio for not too fearful investors.
• 50% of the portfolio is based on 2 safe dividend stocks from the telecom and tobacco sector.
• A diversified mix of 4 stocks from the beaten commodity sector boosts yield.
• The overall starting yield stands at 6.5%.

The good thing about declining share prices is that dividend yields go up. It has become easier to find stocks that offer more than 5% yield, although most of the higher yields are associated with a certain risk. The idea here is to put together a simple portfolio beyond the beaten tracks, more risky than a the classical dividend growth approach based on conservative stocks such as Procter & Gamble (PG), Coca Cola (KO), Microsoft (MSFT), or Johnson & Johnson (JNJ) and the likes, but with a dividend yield that is almost twice as high.

Particularly in the in the beaten commodity sector more than 6% or even 7% yield can be found, and this includes large caps which are among the leaders in their industry. The oil sector is one obvious area to look for, but also mining is good for exceptional yields.

Obviously, these yields are associated with a certain risk, namely the fear that depressed commodity markets will sooner or later force companies to cut their dividends. Therefore, if you are looking for fool-proof income investment with almost zero risk you may as well stop reading. The investment horizon for the portfolio is long-term, and the primary focus is to benefit from dividends, although in the long run capital appreciation for the currently low priced stocks should add to that.

I have developed a small portfolio consisting of only six stocks with an average starting yield of 6.5% for not too fearful investors. 50% of the portfolio is based on two rather fool-proof dividend growers with a minimum risk for dividend cuts anytime soon ("Safe Income Providers"). The other half comprises four stocks from the commodity sector ("Dividend Yield Boosters"). Each one yields close to or more than 7% which signals a certain risk that the market does not consider the dividends to be super-safe. The dividends provide income or can be reinvested which is what I intend to do with the distributions.

The six stocks are AT&T (T), Philip Morris (PM), Shell (RDS.A), Potash Corp. (POT), BHP Billiton (BBL), and Rio Tinto (RIO). T and PM each represent 25% of the portfolio and provide a safe and growing income stream. 12.5% of the capital is allocated to each of the others. Their yields are higher, and although I think that the companies are well prepared to master a period of depressed commodity prices, the risk for dividend cuts cannot be neglected.

The current overall dividend yield is 6.5%. I already own four of the stocks and intend to build up positions in the remaining ones on days of market weaknesses.

The 6.5% Yield Income Portfolio

	% of Portfolio	Share price	Annual Dividend	Payment	Yield
AT&T	25%	32.53	1.88	quarterly	5.8%
Philip Morris	25%	79.46	4.08	quarterly	5.1%
Shell	12.5%	48.18	3.76	quarterly	7.8%
Potash Corp.	12.5%	19.70	1.52	quarterly	7.7%
BHP Billiton	12.5%	31.27	2.48	interim+final	7.9%
Rio Tinto	12.5%	33.76	2.265	interim+final	6.7%

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Safe Income Providers

AT&T's current yield stands at 5.8% and the stock provides a safe income stream. I assume that not too many will doubt the company's capability to pay its dividend in the next decade or so. In addition to that, shareholders can expect a continued increase of the quarterly dividend by one penny, similar to AT&T's raises in the recent years, delivering a dividend growth of about 2%.

PM is the second safe component in the portfolio. It is the highest yielding of the major tobacco stocks and currently offers 5.1%. The company is facing headwinds from the strong dollar which results in declining EPS in 2015. However, the underlying business performance is solid, and without negative foreign exchange rate effects, earnings would actually grow. PM generates less free cash flow than it used to, and it has stopped buying back shares for the time being. Dividend growth has slowed down, and the recent dividend hike of only 2% to $1.02 may be a rate investors might have to get used to, at least in the next one or two years. Despite the negatives, I consider PM's dividend as safe, and the low share price gives a good starting yield with the outlook of future dividend growth as well as share price appreciation once currency headwinds abate.

Dividend Yield Boosters

Shell is the representative from the oil & gas sector in my portfolio, and the yield of close to 8% is extraordinary. I have picked Shell, because it is not a pure E&P company, but includes downstream activities which add some stability in the current phase of low oil prices. Like many others in the sector, Shell's cash flow does not cover capex and dividends, however the company has committed itself to at least constant dividends in 2015 and 2016. Furthermore, Shell has a proven track record of dividend continuity, and it has not cut the dividend for 70 years. There is a certain risk that this history could end, and obviously nobody knows where the oil price is heading and how the situation could look like beyond 2016. However, I doubt that such a scenario will become reality, and Shell is one of the industry majors and likely to be one of the last ones to cut the dividend.

POT got beaten really badly over the last weeks. Worries about declining potash prices and growing overcapacity have brought the share price even below $20. On the other side, the dividend yield which is well covered by the company's cash flow, increased to 7.7%. Although POT had to reduce its guidance twice during the course of the year, it will most likely report EPS more or less at last year's level. Therefore POT is different from other stocks in the commodity sector which see earnings decline dramatically. I am not too optimistic about the potash market, but POT is a low cost potash miner with cash production costs below $100/ton. The company is still highly profitable, even if potash prices stay at the present levels. In fact, POT's potash segment is doing quite okay with a constant earnings contribution, the declining estimates are owed to the nitrogen fertilizer business. Mid-term, POT will also benefit from lower capex which helps to stabilize the free cash flow which will in turn support the dividend. While I do not see much potential for the share price to recover in the near future, I also have little reason to assume that POT's dividend could be in danger anytime soon.

BHP Billiton is one of the major diversified mining companies, with iron ore, copper, oil & gas as the dominating earnings contributors. The yield for BBL stands at a whopping 7.9% and it is the highest yielding stocks in the portfolio. While the price for iron ore, BHP's largest segment, has remained relatively stable during the past months, the petroleum and the copper segment are facing more pressure. In the current pricing environment, the company's cash flow will likely not be able to cover capex and dividend payments, but the situation is not as bad as in the oil industry. Furthermore, it will improve in the next financial year as a result of declining capital expenditures. For an interim period, BHP can easily cover dividend payments with a moderate increase of debt. BHP is committed to a growing or at least stable dividend, and the company emphasizes that it has not cut the dividend during the Great Recession.

Rio Tinto is similar to BHP, but it lacks exposure to oil & gas which is a plus. The dividend yield of 6.7% is lower than BHP's which signals that the market is obviously less pessimistic. Rio Tinto is the lowest cost iron ore miner and the most profitable one. The company's diversified portfolio also comprises aluminum, copper, coal, and diamonds & minerals which adds diversification. Rio Tinto is committed to grow dividends as well and has launched a buyback program at the beginning of the year which is still running. Like BHP, Rio Tinto has to struggle to generate enough cash flow to cover both capex and dividends during a period of depressed commodity prices, but the company maintains a very solid balance sheet.

Balancing The Risk & The Beauty Of Dividend Reinvesting

When having a long-term investment horizon, the relevance of dividends and dividend reinvesting becomes very important. The beautiful thing about high yields is that shareholders receive substantial distributions which allow to reinvest a rather large sum of money. Assuming unchanged share prices, a 6.5% dividend reinvested each year doubles the original capital over an eleven year period.

	Starting Balance [$]	Dividends [$]	Ending Balance [$]
Year 1	10,000	650	10,650
Year 2	10,650	692	11,342
Year 3	11,342	737	12,079
Year 4	12,079	785	12,864
Year 5	12,864	836	13,700
Year 6	13,700	891	14,591
Year 7	14,591	948	15,539
Year 8	15,539	1,010	16,549
Year 9	16,549	1,076	17,625
Year 10	17,625	1,146	18,771
Year 11	18,771	1,220	19,991

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The portfolio is a combination of stable dividend providers with an already high yield, leveraged by extremely high-yielding shares. The latter bear a certain risk of dividend cuts, but the risk is partly mitigated, because the companies are operating in different sectors. Certainly, demand and prices for all commodities depend on the global economy, and in case of a new crisis, all would be affected, but not all to the same extent. Furthermore, all four companies are leading industry players and have solid balance sheets which will help them to weather many storms. To look beyond the next two years would be foolish, but within this period I consider the dividends as relatively safe.

T's and PM's job is to provide really safe dividends and to reduce the volatility of the portfolio, therefore their share is twice as high as any of the other stocks. Even if all four commodity stocks cut their dividends by half, the overall yield would still stand at 4.6%.

At the moment, the market is very pessimistic about commodities and nobody believes that the situation can improve anytime soon. I believe that in the long run, this bear market presents an attractive long-term opportunity. The market is likely to remain volatile over the next months, hence investors buying today must be prepared to see potential paper losses, but in the long run, the outlook for capital gains are not bad. Until then, each stock pays investors well to wait for higher prices. The dividends generate income or alternatively allow to reinvest the distributions, increasing the basis for future payments further.

Conclusion

Lower share prices have brought back dividend yields that were not seen for a few years. In the beaten commodity sector leading companies are on sale, despite their unusually high dividends. While investors have to live with a certain risk that these dividends cannot be maintained, they offer the opportunity to build a steady income stream starting from low entry prices for the bold. A portfolio consisting of 50% safe income plays and the other 50% based on high-yielding stocks from the commodity sector offers a starting yield of 6.5%.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation, any material in this article should be considered general information, and not relied on as a formal investment recommendation. Before making any investment decisions, investors should also use other sources of information, draw their own conclusions, and consider seeking advice from a broker or financial advisor.

Disclosure: I am/we are long T, BBL, RIO, RDS.A. 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.