Use a Barbell Approach for Weighty Gains

 | May 04, 2012 | 3:30 PM EDT  | Comments
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Stock quotes in this article:

mrk

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unl

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pep

The recent negative headlines out of Europe, the downward blip in U.S. Labor growth and the subsequent selloff in the U.S. stock market are stark reminders that investment risks and volatility continue.

Rather than try to time the "risk on" or "risk off" trade, we suggest using a portfolio construction barbell approach designed for versatility in either environment. The goal is to have half your stocks targeted to achieve healthy appreciation with the other half geared to providing stability and income, with lower appreciation expectations.

Today's recommendations focus on the high-dividend stability half of the portfolio. These are good opportunities in stable companies that look likely to participate meaningfully in a global economic rebound and expansion, while also acting defensively in a potential downturn. These stocks won't have the supercharged reaction to an improving economy that a deep cyclical company might, but their persistent operating performance in all types of environments should allow for slow and steady stock market performance.

Merck (MRK) is a major pharmaceutical manufacturer that also participates in the vaccines, consumer products and animal health businesses, operating worldwide. Its Januvia for diabetes has become a blockbuster, and is still is projected to grow strongly. Merck's new product pipeline has a good chance to offset the patent cliffs overhanging many pharmaceutical companies as the patents on their large, profitable drugs expire. MRK has wisely downsized its infrastructure and broadened its revenue base to make its earnings outlook more sustainable. The stock sports a healthy 4.3% dividend yield that can grow, and it is modestly valued at 10.3x estimated 2012 earnings of $3.80 per share.

Unilever (UNL) is one of the global leaders in foods and consumer products. Its brands are recognizable names in almost every household worldwide. The company was early to recognize the potential in emerging markets and it has the largest exposure to these fastest growing regions vs. any of its competitors. Consequently, Unilever should have the best growth rate in its industry. While sluggishness in its home European markets and commodity costs will weigh on growth, earnings are still expected to progress more than 10% annually for the next couple of years. The stock earnings multiple of 16x is justified by this superior growth, and its 3.7% dividend has room to grow faster than earnings.

Pepsico (PEP) has suffered by comparison with its bigger competitor in beverages, Coca-Cola (KO), but its global snack food business is the company's real powerhouse. Management is under the gun for its soda brands' poor performance (especially since Coke has done well), and many shareholders have questioned whether separating beverages from snacks can drive the stock. For now, the company has determined that the whole is worth more than the sum of the parts, but management has also realized it has underinvested in its brands. The newly welcomed marketing and product spending will likely impair earnings this year, but could lead to a reacceleration in the business, perhaps by year-end. The stock trades at 15.2x next year's estimated earnings, and shareholders are nicely paid to wait with a 3.2% dividend yield.

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