Friday, April 10, 2009

Stocks to Inflation-Proof Your Portfolio

By Jon Herring

“Put out the fire first and then think about the fire code.”

That was Ben Bernanke speaking at the London School of Economics a few weeks ago. He was talking about his efforts to re-inflate the bubble economy with every tool at his disposal, including helicopters filled with cash.

What it sounds like is that he lacks an exit plan. And even if he does, there is little doubt that the unprecedented (at least in terms of the world’s reserve currency) monetary inflation we are seeing, will eventually lead to consumer price inflation. The only question is timing. So with inflation hedges still cheap, now is the time to prepare.

You should certainly have some allocation to precious metals and energy. If you have the portfolio size to justify it, your precious metals holdings should be divided among a graduating risk strata, with the foundation of your holdings in physical metals stored in a safe place (not a bank deposit box), then mining stock ETFs or mutual funds, followed by individual major mining stocks, and finally some of the smaller mining stocks and junior companies to round out your allocation.

Years ago, I would have suggested a 10% allocation to precious metals. Today, considering the incendiary efforts of the world’s central banks to “put out the fire”, I believe up to a 30% allocation is prudent and reasonable – as long as you have a time horizon of at least a few years and can withstand some volatility.

But historically speaking, the best long-term inflation-fighting assets are rock-solid companies with a long history of paying and raising their dividends. And with the S&P dividend yield near 20-year highs, now is the time to begin accumulating these stocks.

Note that I suggest accumulating. I do not believe we have seen a bottom for the stock market. But picking bottoms is a fool’s game. Your long-term investment analysis should focus on companies, not the market. And when you see world-class companies with a dominant competitive advantage, selling for low valuations, you buy them – especially those with a long history of raising their dividend payments.

Here is why that is so important.

Let’s assume you buy a stock for $50 that pays $2.50 in dividends annually. That equates to a 5% dividend yield. We’ll assume you own 100 shares. So your original investment is $5,000 and your first year, you receive $250 in dividend payments. Now, let’s assume the company raises the dividend by 10% each year. In this case, the dividend on these shares would be $3.66 after five years (representing a 7.3% yield on your original investment)… and $5.89 after 10 years (representing a 12% yield on your original investment). That would equate to the annual long-term return of the stock market itself. By year 15 your dividend payments would equal $9.49 annually, per share. That means you would be making $949 per year on your original $5,000 investment… a yield of 19%.

When you are holding the stock, you aren’t interested in the “current yield” based on the stock’s price at the time. Your yield is based on when you invested in the stock.

If you were to re-invest those dividends over the years, the compounded return would be significantly higher. And compounding is the key to wealth. That’s why you should always seek investments that generate a positive cash flow. Dividend growth and compounding are how Warren Buffett currently receives dividends from Coca-Cola that equate to a 30% annual yield on his original investment.

That’s good work, if you can get it. And you can…

Every quarter, Mergent publishes a list called the “Dividend Achievers.” These are companies that have raised their dividends for at least 10 years in a row. You can buy the list through Amazon. You might also consider the “Dividend Aristocrats” these are companies that have increased their dividends for 25 consecutive years.

Choose the companies with the highest 10-year dividend growth, then reinvest the dividends and hold these stocks for as long as possible. The miracle of compounding will make you wealthy… and the growing yield will protect your portfolio from the coming inflation.

You might also consider Master Limited Partnerships (MLPs). These are companies with a special tax status that hold energy transportation assets – usually pipelines. Right now, as a group, these companies are paying a safe 10% yield.

MLPs also have inflation adjustments built in to the rates they charge to transport the fuel – so your dividends will go up as inflation rises. These companies are also inherently extremely safe. After all, you’re investing in a pipe that is buried underground. Once the asset is built, you just sit back and collect your dividends for years to come.

Inflation is coming. Buy gold and silver to protect your wealth. But don’t forget to load up on select dividend-payers too.

To your success, kingsley. 

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