A Peek at Jim Cramer's Portfolio


(Editor's Note: Jim Cramer will be at the Borders in Westbury, NY at 7:30 p.m. on Dec. 15 to discuss the following excerpt on diversified dividend portfolios and more investing ideas from his new book Getting Back to Even. You can also meet Jim and get your copy signed.)

Given all the benefits you get from owning stocks with high dividend yields, is there anything stopping you from putting together an all-dividend portfolio? Would that high yielding portfolio pass our standards of diversification as long as all of its stocks were in different sector, or would relying on dividend income for such a large portion of your returns be too much like putting all of your eggs in one basket? Remember, there are certain factors like inflation and interest rates that make dividend-paying stocks more or less attractive as sources of income relative to other investments. You could see how that might theoretically cause all high-yielders to trade closely in line with each other, but compared to other factors, like whether a stock's sector is in or out of favor, the attractiveness of its dividend as a source of income is just not that important, not as inconsequential as a drop of water in the ocean, more like a few buckets of water in a swimming pool.

So here's what I would say about whether a portfolio of all high-yielders could be diversified: it depends. You would be walking a fine line between diversification and non-diversification, but not because all your stocks would have big dividends. Bear in mind, when we talk about a diversified portfolio of stocks we mostly mean diversified by sector. And companies that pay consistently large dividends are hard to find in some sectors and plentiful in others. Even if you did make sure there was no overlap, you still would lack some important groups like fast-growers, and growth is precious on Wall Street. It's hard for me to imagine an event that made paying a dividend a huge liability and crushed every high-yielder out there, especially since the companies could simply eliminate their dividends.

So there's a place for a dividend portfolio, definitely. And that place, at least for most of you, would be your Individual Retirement Account, better known as IRA, where you could reinvest your prodigious payouts and let them compound tax-free for years, even decades. The dividend tax rate may be a paltry 15%, but I would rather keep that 15% for the purposes of growing my capital, as an IRA allows you to do--no taxes on anything inside the account until you pay income tax on the money you withdraw after you have retired. That's a subject I'll tell you more about later, for now let's concentrate on using high-yielders to get your retirement portfolio and your non-retirement or as I call it, your discretionary portfolio, back to even, the milestone you need to reach with your money before you can get rich.

To that end I have put together a diversified portfolio of intentionally high-yielders with the help of Dave Peltier, who knows all of this stuff cold as the writer of the Dividend Stock Advisor newsletter, part of the line-up of excellent services TheStreet.com offers to investors seeking knowledge about investing and rigorous analysis in this most critical area. Granted, it's my own company I'm writing about, but it really does offer subscribers practically endless resources. With Dave's assistance I came up with five terrific stocks, or actually four stocks and one ETF, which you can pick and choose from, use as the template for a dividend portfolio, or simply view as examples of what to look for, not just in a high-yielder, but in any stock before you buy.

What I am about to do is considered the height of insanity by anyone who writes about stocks. Many of these people are either afraid or unable to recommend a stock in a column, but a book? What the heck am I thinking? I could be wrong! And it would be in print forever! Anyone who picks stocks will be wrong sometimes, that's why I've spent so much time teaching how to minimize the damage from these inevitable mistakes. The real reason I feel like I'm putting my head on the chopping block is that you could pick up this book a year or two from now, and in that time just about anything could happen to ruin one of these stocks, or the fundamentals could change in a more subtle manner, making these stocks more dangerous. I can live with being embarrassed, but what I cannot handle the idea that you might lose money, especially after all that's already been wiped out by the crash and the real estate collapse, because you bought one of these stocks after the fundamentals had changed and the story no longer made sense. You need to promise me something. It's the same thing I always demand from anyone who wants to own individual stocks: do some homework before you any of these stocks. Don't think you can be lazier with these stocks just because I put them in a book. Understood? Good, because I don't want you reading this list unless you're willing to research these stocks like any others. Here they are, the five stocks in my Dividend Defensive Line.

1. Eli Lilly (Stock Quote: LLY): With a hefty 5.8% yield, the Indianapolis-based Lilly has one of the highest yields of any big pharma major pharmaceutical company, and it's the only member of that cohort still consistently raising its dividend. Pfizer (Stock Quote: PFE) cut its payout, while Wyeth (Stock Quote: WYE), Merck (Stock Quote: MRK), and Bristol-Myers (Stock Quote: BMY) are just holding pat. Lilly's willingness to raise increase its payout is sign of strength that you will find nowhere else in big pharma. The company made some smart acquisitions in 2008, including buying ImClone for $6 billion.

The ImClone acquisition was worth every penny. Its strong biotech franchise provides immediate growth, the kind that companies like Lilly salivate over, thanks to the cancer drug Erbitux. The acquisition also helps bolster Lilly's drug pipeline before its current top-seller, the anti-psychotic Zyprexa, stands to lose patent protection in 2011. Thanks to Erbitux, Lilly is now one of very few companies with a strong anti-cancer franchise, a category of drugs that governments around the world are still willing to reimburse insurers for. That matters at a time when almost every developed country faces ballooning budget deficits, and the President of the United States is committed to cutting healthcare costs.

How about that dividend? Eli Lilly has boosted its payout for 41 consecutive years, most recently in December 2008 when it raised its quarterly dividend to 49 cents a share, which comes to $1.96 annually. How does Lilly stand up to the safety test? The company can cover its payout 2.2 times with expected 2009 earnings of $4.22 a share. Two thumbs up, way up. And since Lilly's profit is expected to grow another 7% in 2010, we will likely see more dividend boosts here. Eli has a fair amount of debt on its balance sheet, but it still garners an A-rating from the major agencies. Part of this is because the company only has $400 million coming due in 2009, and nothing else until 2012. No need to worry on that front, either. But not everything is smooth sailing in this stock.

Lilly's biggest fear and for the entire industry is the potential pressure that President Obama could exert on pricing with the group. That's why I picked the high-yielder with the best earnings coverage in the industry, and a decent balance sheet to boot. As one of the largest employers in Indiana, a swing state, Lilly has strong support among the state's senators and congressmen, which has allowed it to get maximum reimbursement for its breakthrough mental health drugs.

2. Consolidated Edison (Stock Quote: ED): Better known as Con-Ed, this Manhattan based 6.4% yielder has the highest yield of all the regulated utilities whose debt gets an A-rating from the major credit rating agencies. In January of 2009 Con-Ed boosted its dividend for the 34th consecutive year and now has a quarterly payout of 59 cents, adding up to $2.36 annually.

Unfortunately, covering that dividend will eat up 74% of the company's expected 2009 earnings of $3.21. Normally, you know that to consider its dividend safe a company's earnings should be at least twice the size of the payout, so that it eats up only 50% of earnings or less. Con-Ed, however, is not a normal company. State regulators set the rates that Con-Ed and other utilities can charge, as well as the return on equity that they can earn. In April of 2009 Con-Ed was granted a $721 million rate increase and demand for electricity should pick up once the economy begins to recover, two reasons to feel far more comfortable that ConEd's long history of dividend boosts won't come to an ignominious end any time soon.

Part of the reason Con-Ed got that rate hike is its terrific management. Its CEO, Kevin Burke, is a long-time utility executive who knows the in-and-outs of the regulatory regime. Unlike other utilities, Con-Ed's earnings are far less vulnerable to the possibility of climate change legislation like cap-and-trade, as it stopped burning coal decades ago and has in fact sold most of its electric generation business. Rather Con-Ed is focused on the most basic of utility businesses, transmitting and distributing, electricity, natural gas and steam to its customers.

2. AT&T (Stock Quote: T): along with Verizon (Stock Quote: VZ) (which could just as easily have been on this list as it's just as good as a company and a stock, but AT&T won the coin toss) AT&T is dominating the wireless space, and paying you a 6.4% yield to watch it happen. We all know the iPhone has been a big winner for the company, bringing over new customers, who are paying for a more expensive, high-speed data plan. AT&T's U-verse television offering has also quickly reached 1 million subscribers, though both of these growth drivers are somewhat offset by the loss of traditional landlines, once the company's bread and butter. This isn't your old Ma Bell, but a super high tech company that is at the cutting edge of all things communications. Despite the losses in the plain old-fashioned telephone business, wireless customers are spending more per user than ever. And through cost cutting, the company's operating margin has been steadily climbing.

In December of 2008, AT&T raised its dividend for the 24th consecutive year, with a new quarterly payout of 41 cents a share, adding up to $1.64 for the full year. AT&T's dividend will eat up 78% of its expected 2009 earnings, which is nowhere near as safe as we would like. But AT&T deserves some leeway here because of its stable business, which also has room for price increases for its services. Even though the earnings don't come to twice the dividend, AT&T does pass the free cash flow test, as it generated 43% more free cash flow than reported net income over the past 4 quarters. It's debt is also rated in the A-range by the major ratings agencies, and it has a terrific CEO in Randall Stephenson.

3. Powershares Financial Preferred Portfolio (Stock Quote: PGF): This is not a stock, but an exchange-traded fund or ETF that yields roughly 11.6% and follows 30 preferred stocks in the financial industry, allowing you to gain exposure to multiple different companies without concentrating too heavily on any particular one. Preferred stocks are like a hybrid security that's half-bond and half-stock. First, the dividends are fixed, like a bond. And if there's not enough money to pay all of a company's dividends, preferred holders get their money before the common stock dividend can be paid, the same as if the business is liquidated--preferred shareholders come before the common when it comes to receiving any available proceeds from liquidation. In return, you usually give up voting rights and some potential upside if the common stock really takes off--like we saw in the financials after the bottom in early March of 2009.

This ETF could come in handy, as banks will have to pay high preferred yields to survive in this difficult environment in order to raise capital. The underlying index that this ETF tracks is a market-capitalization weighted portfolio from Wachovia, now a subsidiary of Wells Fargo, that is subject to their own selection methodology. It does include some international exposure.

The ETF has paid a monthly dividend since inception in 2006, ranging from 10-12 cents of late. Based on the most recent payout of 11.404 cents, the fund yields 11.6%. That's about 4 times the average yield of the benchmark S&P 500. I am including this ETF because I don't want to single out any particular bank preferred for fear that the bank might stumble, but taken collectively the yield here is simply too juicy to ignore, now that it seems very unlikely that the government would nationalize the banks.

4. Kinder Morgan Energy Partners (Stock Quote: KMP): this company is what's called a master limited partnership, an MLP, and MLPs like this one are often referred to as energy trusts. These MLPs pay no corporate taxes, and pass almost all of their earnings on to shareholders in the form of a distribution, which is very similar to a dividend. KMP yields about 10%, although with this kind of company the yield tends to be volatile as the distribution changes every quarter depending on how much money the company makes. The company is a pipeline operator with 26,000 miles of lines and about 170 terminals. As opposed to other companies that bring oil and natural gas out of the ground or refine it into other products, Kinder is more like a toll collector that earns money by storing and transmitting the commodities from one place to another. The tolls never stop coming as the customers rely on KMP's pipes for almost a ton of their natural gas use.

Kinder Morgan has steadily raised its payout every quarter or two since 1997. The company currently pays out $1.05 a quarter, which management can more than cover with internal cash flow. Kinder Morgan is larger than most of its peers and still has decent access to capital. The company is not shying away from new potential growth projects (when backed by long-term contracts) that the competition is not in a position to undertake, which means it could be able to raise its payout for years and years to come.

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