The Rest of the Barbell

 | Oct 09, 2013 | 12:00 PM EDT
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Today I will wrap up my quick refresher course on income investing. My barbell approach is probably different than most of the income suggestions you will run across but, as John Templeton warned us, it is tough to excel by doing what everyone else does. I prefer buying a wide variety of alternative higher yielding income assets, including Business Development Companies (BDCs), private equity related firms, undervalued real estate investment trusts (REITs) and high yielding common stocks. By owning a lot of them and buying below asset value, you set up accidental diversification and certain margin of safety for the portfolio. Stay small in individual position size and move slowly by only buying when they dip below asset value. This should be about half of your income portfolio.

The other half of the portfolio needs to be devoted to dividend growth stocks. The stocks must be paying some sort of dividend but the key element is the level of dividend growth that can be expected from your stocks. While all future events are difficult to predict I have found that the projections form the mathematical models in Value Line are as accurate as any analyst projections I have seen over the years so I rely on those. They may not have the magnitude exactly right but the growth rate of the dividends has followed along the approximate trajectory most of the time.

I am also a notorious cheapskate when it comes to buying stocks so I will add some valuation criteria as well. A basic approach modeled on the teachings of Ben Graham is to limit our purchases to stocks that trade at less than 1.5x book value and less than 15x earnings. In addition, multiplying the price-to-earnings ratio (P/E) by the price-to-book ratio should give us a product of less than 22.5.  A portfolio of companies with high dividend growth potential bought at this level should serve us well over a long period of time.

We end up with some interesting names on the list that should deliver strong appreciation as well as income for long-term investors. Several banks made the grade -- even after the regionals have put in a strong showing this year. Many banks halted or reduced dividend payments during the credit crisis and have again begun paying and even increasing payouts as conditions are improving. This should continue, and I expect banks to be the sector with the highest dividend growth over the next five years. Our screen produced Fifth Third Bank (FITB), Huntington Bancshares (HBAN), Associated Bancshares (ASBC) and Susquehanna Bancshares (SUSQ).

Corning (GLW) has been one of my favorite stocks for some time now. Although it is above my price preference as an absolute asset based value investor, it is worth owning for long-term income and appreciation potential. The company's glass products are used in some of the highest growth segments of the economy including mobile tech, healthcare, environmental services. Gorilla Glass is quickly becoming the standard for mobile electronics devices such as smart phones and tablets and should be the initial driver of strong growth for this company. Trading at 11x earnings and 1x book value, it's cheap and the 2.86% yield show grow in the mid-teens range for several years.

I like Brooks Automation (BRKS) for long-term income investors as well. The company makes semiconductor equipment such as factory automation and wafer handling devices for a range of industries including flat screen TV manufacturers, data storage companies and the life sciences industry. The company has undergone a turnaround that is now starting to work and they should be able to rapidly increase the already generous 3.5% yield. Trading for less than book value and about 6x earnings right now the stock is certainly cheap enough.

These are some of my favorite stocks for the dividend growth half of the barbell. It is pretty easy to put together a list of qualifying stocks with a Web based screener, but the most important part of this process is your attitude toward the portfolio. You need to ignore the day-to-day price movements of the portfolio and treat it like a five-year fixed-income investment. Monitor the portfolio for serious changes in financial conditions of the individual companies, but for the most part leave it alone and cash the dividend checks. If you stay small, move slow and apply generous doses of common sense and patience, this approach should meet your income needs and maybe even grow a bit over time.

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