The Cyclical Portfolio For The Dividend Investor

Includes: CAT, CMI, GE, IBM, MO, PG, T
by: The Independent Investor

Nobody likes to hear their investment strategy talked about in over generalizations. Investing usually includes discussing and understanding indexes, sectors, and types of companies, and no two companies are the same.

While the market has been very volatile over the last several years, one of the worst arguments that many traders and investors have consistently made during recent sell-offs is that cyclical companies could not be bought at any price.

The definition of a cyclical company is a company whose earnings are significantly linked to business cycles. While most investors understand investing in cyclicals fairly well, many investors simply continue to refuse to invest in these more volatile stocks in an uncertain economic environment.

It seems intuitive. If the economy is weak and businesses core products and services are heavily tied to the business cycle, don't buy cyclicals. The problem is that understanding what phase of the business cycle the economy is in has become much more complicated. With leading economic indicators have been up and down over the last three years, many investors have come to view cyclicals as an asset class for traders, not long-term investors.

This is why I question the idea the economy is really as weak as many dividend investors would have you believe. It is also why I think many dividend investors are oversimplifying a number of sectors with fairly diverse and unique companies. Not all cyclicals are created equally, and while companies on short-term business cycles have seen these companies' earnings fluctuate significantly, companies on longer-term business cycles have continued to consistently report strong earnings over the last several years.

Two examples of well-known companies on shorter-term business cycles are Cummins (NYSE:CMI), Caterpillar (NYSE:CAT). Most of Caterpillar's core businesses strengthen and weaken as demand for industrial equipment rise and falls with the business cycle. Cummins core products, diesel engines, are heavily tied to demand for new trucks. Since the market looks at both of these companies as extremely cyclical, these stocks are priced at 8-10x average estimates of next years likely earnings, and these companies' share prices are very volatile, and the growth outlook remains uncertain.

GE (NYSE:GE) and IBM (NYSE:IBM) are two of the strongest performing companies on longer-term business cycles. Both IBM and GE offer significant cost savings and operate primarily on multi-year contracts, and strong corporate balance sheets and low rates has kept demand for the products and service these industry leaders offer fairly strong over the last couple years. Both of these companies also trade at a historically cheap multiples of nearly 12x average estimates of next year likely earnings.

I believe buying companies on longer-term business cycles is the best strategy in the market today for dividend growth investors with a long-term outlook for several reasons. First, these companies' have more stabile business models and stronger cash flow than most cyclical companies on shorter term business models. Second, these companies' are more comfortable paying out a higher percentage of annual revenues in dividends because these companies have more stabile business models. Third, these companies' have consistently been mispriced by traders and investors, and these stock are likely moderately to significantly undervalued if growth estimates improve even modestly over the next year.. The volatility of these companies' share prices also creates great long-term opportunities for dividend growth investors to dollar cost average by reinvesting dividends.

Value is the most important criteria for almost any investor, and dividend growth investors are not entirely different. Investors will always have different goals because of age, risk tolerance, income, and numerous other considerations. Still, dividend growth investing and investing for total returns are not fundamentally different. Dividend growth investors believe investing in undervalued companies with solid growth and strong free cash flow will enable these individuals to maximize income and total returns over the long-term. Growth investors usually simply focus total returns, and these individuals are not concerned with income and dividend payments.

While I am s 29-year-old investor who also trades, I have advised a number people who are in their late 50s that are at or near retirement. These individuals are primarily focused on capital preservation and income more than total returns. Over the last year I have strongly advised many of these individuals to rebalance their portfolios, and begin selling moderately to significantly overvalued dividend stocks such as Altria (NYSE:MO), AT&T (NYSE:T), and Procter & Gamble (NYSE:PG).

Here is what an ideal cyclical portfolio should look like in my opinion for a long-term dividend growth investor that is focused on capital preservation, income, and total returns.

Company Buy Target Dividend Target Valuation 1 Year Target - Price at Which Dividends Are No Longer Reinvested Short-term
GE $18.50 3% Yield or Higher $25 $22
IBM $185 1.8% Yield or Higher $240 $220
CMI $85 2.5% Yield or Higher $120 $105
DE $72 2.5% Yield or Higher $90 $85
BP $39.50 4.8% Yield or Higher $50 If Oil Is at $100 $45
SDRL $$34 7% Yield or Higher $45 If Oil Is at $100 $40
CAT $78.50 2.5% or Higher $100 $92

(Note: Buy Targets Are Prices All of These Stocks Were At Within the last Month As of 8/8/2012)

Obviously most investors at or near retirement are primarily concerned with income and capital preservation. So I have recommended that between 40% to 60% of the equity portion of an individuals portfolio is overweight cyclicals with dividends of at least 2.5%. The one exception is IBM, since this company has doubled its dividend every 5 years since 1997. Right now I believe investors focused on income should be around 60% overweight cyclicals, with at least 70% of the cyclical companies held having longer-term business models. I would recommend reinvesting dividend payments in these stocks unless they exceed the listed 1 year targets. Dividends could be reallocated to bonds or lower risk dividend stocks if cyclical companies exceed these short-term targets.

I believe this portfolio is ideal for longer-term investors because I think these cyclical companies with longer-term business models will provide significantly greater income and total returns than most consumer staple companies over the next decade for several reasons. First, these companies have pricing power and will be able to offer inflation adjusted returns. Second, these companies all have a strong history of consistently raising dividend payouts and focusing on maximizing shareholder returns. Third, these companies have all consistently reported solid earnings and consistently raise dividend payouts over the last three years.

To conclude, while no two investors will have identical investment strategies, the best portfolios will always be focused on the future, not the past. Dividend stocks such as AT&T, Altria, and Procter & Gamble, are now valued at the highest price to earnings ratios these companies have ever been at, and analysts are expecting minimal growth from these industry leaders over the next five years. Likewise, most Cyclical companies remain historically cheap, and companies on longer-term contracts with solid earnings and access to historically cheap capital continue to offer investors good value and steady income.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.