An Antidote for Inflation Anxiety

By Robert Barker

If the threat of falling bond prices didn't scare you in June, it should now. I don't say that just because the Lehman Brothers (LEH ) Aggregate Bond Index in July suffered its worst month since 1981. With President Bush now making it plain that war on terror means far higher government spending, budget deficits are inescapably headed up.

Megadeficits, in turn, raise the specter of inflation, a tempting way for Uncle Sam to ease his debt burden. Anyone who lived through the 1970s will recall the bond market welcomes inflation as much as pols relish tax hikes in election years.

Given this growing inflationary danger, it's only prudent to consider lightening up on bonds. Yet if you depend on interest payments from bonds to cover part of your living expenses, you will need to generate income from your portfolio in other ways. Money-market funds, now paying less than 0.9%, will hardly do. So I decided to see if I could build a portfolio of steady, dividend-rich stocks. With a hypothetical $500,000 to put to work, I aimed to pick a diverse group of no more than 10 stocks capable of generating more income after taxes than intermediate-term municipal notes now pay.

First, I turned to a Standard & Poor's (MHP ) database filled with details on more than 4,500 stocks. With it, I set up a computer search with a long list of criteria. To survive the first cut, a company had to have reported a net profit over the past 12 months and be expected by Wall Street to remain profitable this year and next. It needed to have posted positive cash flow from operations. Also required were a minimum stock market capitalization of $1 billion and, to avoid exchange-rate or foreign tax worries, a U.S. domicile. I wanted as well to see that each stock's volatility as measured by "beta," or how much a stock zigs and zags relative to the broad market, was low. All this, plus a minimum 3% dividend yield, drew 11 semifinalists.

Next, I looked to find evidence that the dividend payments are secure. So I applied this harsh test: No company could stay on the list unless its free-cash flow -- cash flow from operations minus capital spending -- over the past year was higher than total dividend payments. In other words, I only wanted companies whose operations created enough cash to fund everything. This cut chemical giant DuPont (DD ), equipment financer GATX (GMT ) and natural gas distributor Nicor (GAS ).

That left eight solid prospects (table). The group's share prices have fluctuated on average half as much as the S&P 500-stock index. Its dividend payments account for 40% of aggregate free cash flow, and the eight stocks yield an average of 3.7%. Does this mean a dividend cut is out of the question? No. Indiana-based NiSource (NI ) a natural gas utility, in July said that in November its annual dividend rate would fall 20%, to 92 cents a year, to bolster its credit status and bring its payout ratio in line with peers. Yet others, including ChevronTexaco (CVX ) have recently raised their payouts and still others may do so soon. BellSouth (BLS ) looks to be a reasonable candidate for a boost, with the total payout now just 28% of free cash flow. A spokesman told me BellSouth's dividend has been under review since new, lower tax rates on dividends took effect.

Assume, though, that these eight stocks keep yielding 3.7%. With a $500,000 portfolio and after a 15% tax, that implies $15,725 in annual income. The same money in five-year, AAA-rated munis paying the recent 2.6% average would earn $13,000. Unlike stock dividends, which usually trend up, bond yields are fixed. Stocks court their own risks. But with inflation lurking, bond investors dependent on interest income should keep an open mind to dividend-paying stocks' higher rewards.

Questions? Comments? E-mail or fax (321) 728-1711

    Before it's here, it's on the Bloomberg Terminal.