4 stocks to fight inflation's bite

By Jim Jubak

Things are tough for income investors. Yields are so low -- 2.85% for a two-year Treasury note -- that income investors are losing ground every day to inflation, now running at an annual rate of 4.2%.

But the next 12 to 18 months look even tougher. Probably sooner rather than later, the Federal Reserve will join the fight by the world's central banks against inflation and raise interest rates.

Any increase in interest rates will drive down the price of existing income vehicles. Higher yields on newly issued bonds and stocks will cause the price of existing fixed-income investments to decline until their effective yields climb high enough to match the new rates. A $1,000 Treasury note would have to drop to a price of just $919 to make up for a quarter-point climb in interest rates.

The 'unfixed-income' strategy

So income investors are looking at losing ground to inflation now and seeing higher interest rates take a bite out of the value of their investments later.

Quite a squeeze.

But I do have a fix for the problem. It's a strategy I first wrote about in my April 11 column, "A better way to fight low yields." This strategy, which I'm calling "unfixed-income investing," will enable you to keep up with inflation -- and more -- while growing the yields of your income investments over time. In that column, I picked my first stock for building an unfixed-income portfolio: US Bancorp (USB, news, msgs). Today, I'm going to suggest three more. That will bring me 40% of the way toward my goal of a full-fledged unfixed-income portfolio.

How this strategy works

This strategy starts with common stocks that pay high dividends. My goal is to find equity investments with yields above the percentage paid by five-year Treasury notes (3.54% on June 24) or, ideally, above the yield on 10-year Treasury notes (4.1% on June 24). And these common stocks should be as safe as or safer than the five- or 10-year Treasurys under current market conditions.

Then I add a third criterion: superior histories of raising dividends year in and year out.

It's this last element that gives income investors a fighting chance to beat today's low yields and stay ahead of inflation. How does it work? By putting the power of dividend compounding to work for long-term income investors.

Let me use US Bancorp, my first unfixed-income pick, as an example. The yield on US Bancorp -- 5.73% on June 24 -- is certainly high enough to make the cut. And this conservatively run bank is certainly safe enough. The company did take a $254 million ding in the first quarter of 2008 on the value of some debt securities it had bought back from its money market funds, but the damage in the current financial crisis has been relatively minor. Net charge-offs for bad loans came to $293 million for the quarter. That's about 0.75% of bank assets.

Those figures are low enough to convince me that the bank will ride through the downturn in housing and commercial lending without any big problems. It doesn't hurt that this is one of the most profitable banks in the country, with return on equity well above 20% a year. By the end of 2008 or early 2009, the bank's stock will have recouped the 8% drop from April 11 to June 24. My current target price by year-end remains $44 a share.

Staying well ahead of Treasury notes

But it is US Bancorp's commitment to returning 80% of earnings to shareholders that makes it the first stock in my unfixed-income portfolio. Combine that commitment with the bank's steady rate of earnings growth -- 8.5% annually over the past five years -- and what you get is a stock with constantly increasing dividends for shareholders.

In 2003, the stock paid 86 cents a share in dividends. The dividend payment has climbed steadily to $1.70 a share in 2008, an increase of 98%.

Look at what the power of dividend compounding can do for US Bancorp's dividend yield in the long run. If US Bancorp can grow dividends per share by just 10% this year and next -- that would be below the average annual 16% increase of the past five years -- by April 2010, an investor would be looking at a dividend of $2.06 a share. That would represent a 6.3% yield for an investor who bought at the April 11 price of $32.48 and a yield of 6.9% for the investor who bought at the June 24 price of $29.93.

The current yield of 5.73% is great now -- when the 10-year Treasury note yields 4.1%. And the 6.9% future yield will look even better after Federal Reserve interest-rate increases have cut the prices of all income investments with fixed payouts.

Think of buying a stock like this now as purchasing an option on increasing future dividends and higher yields.

The key: High yields that are safe

It's not easy to find unfixed-income stocks like this, which is why it's taken me so long to come up with three additional picks for this strategy.

The financial sector is the most fertile hunting ground. Prices across the sector have been cut in half since last August. There's nothing like writing off $10 billion in a quarter to send a stock price tumbling. And that has sent dividend yields soaring. Citigroup (C, news, msgs), for example, traded for $18.85 on June 24, down from $49.49 on Aug. 8. That's pushed the yield on these shares up to 6.3%.

The problem, of course, is that the dividends at Citigroup and other big commercial and investment banks such as Wachovia (WB, news, msgs), Washington Mutual (WM, news, msgs) and Bank of America (BAC, news, msgs) aren't by any means secure. Bank of America wouldn't yield 9.45% right now if investors weren't worried that the bank will have to cut its dividend to preserve capital.

Continued: Finding high yields

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