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A proposal for patient compounding and consumer stocks

The best way to overcome this mess is with dividends, says one U.S. advisory, and the best stocks to buy are the ones with pricing power.

In the search for safety, the arguments go back and forth. Dividend-paying stocks, fixed-income securities, cash only?

In the end, your personal choice is probably based as much on your age, personal priorities and temperament as it is on conflicting numbers and arguments. But it doesn’t hurt to marshal as many facts as possible.

So let’s face facts about dividends. Starting with the worst.

Companies can cut their dividends. Even General Electric (NYSE-GE), the oldest surviving name on the Dow Jones Industrial Average, has done the deed. They said they wouldn’t, but they did.

This does not stop a leading American advisory from advocating that your retirement portfolio be built on dividends and the compound interest they bring.

We will follow Richard C. Young’s Intelligence Report as the editor hammers home his philosophy, and see which stocks he thinks investors should take on board to make it work.

The stocks he likes have a quality that he calls “inelastic demand.” That is, demand that won’t quit.

Dividends more important

Mr. Young begins with a survey of the scarred investment landscape. In December 2007, he wrote that 2008 would feel like a depression for some of his readers. “Some” turned into most.

“For 2008, it now looks like the world has lost perhaps 40% of its wealth,” he observes. “In truth, much of this loss was simply a write-down of illusory assets that were never real in the first place.”

That just makes dividends more important, in the editor’s opinion.

“Given the inflationary surge I expect two to three years out, the foundation I have laid down for myself, as well as for you,” he tells his readers, “is patient compounding of dividends and interest. I am especially keen on companies that offer pricing power keyed to inelastic demand.”

That means the so-called consumer staples, the stuff people can’t, or won’t, do without. These companies “are positioned to increase dividends even during the hard times.”

Before we get to the companies in question, we’ll look at Mr. Young’s very precise portfolio plan.

32 names, not less

An individual common stock portfolio “must consist of 32 names,” says the editor, “not 30, not 31. Moreover, this group of 32 dividend-paying stocks must be held in conjunction with fixed-income securities and gold in a 50% fixed, 45% stocks, and 5% gold mix.”

In short, 95 per cent of your portfolio should be at work compounding dividends and interest income. The equities can be a balance of exchange-traded funds (ETFs) and dividend-paying stocks (known as Retirement Compounders in his lingo). Some equity mutual funds might be included.

He breaks the numbers down further. Each of the 32 stocks (or funds) represents 1.4 per cent of the equities in the portfolio and about half that percentage for the entire portfolio.

“As such, an investor with a complete balanced portfolio can suffer a number of individual stock blowouts (I’m not suggesting bankruptcies here) without any damaging effects,” says Mr. Young.

“Proper diversification simply requires a lot of work,” he adds. “Under-diversification can lead to disaster.”

In fact, he goes so far as to say if you don’t have the resources to buy a complete 32-stock portfolio, you shouldn’t have any stocks at all!

Well, that’s the formula he’s been using for over three decades. Now let’s see which dividend-paying consumer stocks top that list of 32 equities right now.

Paying dividends since 1893

There’s no better example of a company with pricing power than Coca-Cola (NYSE-KOK). It has paid investors a dividend every year since 1893. It has shelled out through two world wars and the Great Depression.

A dividend will be paid during the 2009 depression, too, Mr. Young says. In fact, he expects that its balance sheet strength, worldwide market and focus on consistency will allow it to raise the dividend this year.

It is one of the names on his short list of “most advised names” in his monthly countdown of top stocks over the past year. The others all have the same “inelastic demand,” being hardy perennial consumer stocks.

They are rival Pepsi-Cola (NYSE-PEP), British consumer giant Unilever (NYSE-UL) and Sysco Corp. (NYSE-SYY), which brings food services and products to restaurants, health care institutions and others.

“This group of leaders has performed far better than the market as a whole,” Mr. Young states. But they are not the only consumer stocks he likes right now.

Another name on the list is meat packer Hormel (NYSE-HRL). This 100-year old firm has developed high-pressure processing (HPP) which allows it to pack meat with no preservatives whatsoever. The process uses water pressure to kill all bacteria (something other plants might want to make a note of).

Also on this month’s favoured list are jam and jelly maker J.M. Smucker (NYSE-SJM) and North America’s most celebrated chocolate maker, Hershey (NYSE-HSY), which by the way has been paying dividends steadily for over 70 years.

In short, as long as enough people go on imbibing soft drinks and eating chocolate, one group of companies will keep on paying dividends. An occasional outbreak of bad skin would seem to be a small price to pay to keep that corner of the economy moving along.