Start Your Own Dividend Fund and Beat the S&P 500

BOSTON ( TheStreet Ratings) -- This month, I'm starting the Dividend Stars Portfolio, selected from a review of companies poised to provide excess returns over the next 12 to 24 months. The diversified 13-stock portfolio offers investors growth and income.

My Dividend Select screen picks companies that generate above-average dividend yields and show the potential for share-price appreciation. The monthly screen, begun Feb. 14, lists 100 companies that have collectively outperformed the S&P 500 by 4.2 percentage points. (Sign up for our Dividend and Income Newsletter.) The Dividend Stars Portfolio is derived from the Dividend Select screen.

This is an opportune time to assemble your own portfolio of stocks. Interest rates are so low, you're probably not making much on fixed-income securities such as certificates of deposit (CDs) or government bonds. As for stocks, even the best fund managers are producing middling gains because of seesawing markets, and there's a widespread notion that dividend-paying shares, such as those filtered by our screener, are the safest bets out there.

Today I'm highlighting two of the stocks featured in the Dividend Stars Portfolio. There will be more to come over the next few months.

Mattel ( MAT) -- dividend yield: 3.30%

Mattel, the world's largest toy maker, holds a portfolio of the most iconic brands in the world. The company's top five includes Barbie, Hot Wheels, American Girl, Fisher Price and its newest acquisition, Thomas and Friends. Growth has been impressive in the face of a slowing economy here at home and in Europe, where Mattel collects 24% of revenue.

The company's acquisition of HIT Entertainment (which includes Thomas and Friends, Barney and others) makes sense, especially given management's proven expertise at developing and expanding brands (e.g., Monster High, American Girl). The European exposure concerns me, yet is on par with competitor exposure (Hasbro is at 26%), and toys historically have been somewhat bulletproof to economic malaise.

Management has been committed to returning cash to shareholders in the form of dividends and share repurchases. Mattel repurchased 16.3 million shares in the first nine months of the year. In addition, dividends increased 11% from 2010.

The company is trading at less than historic valuations and at similar levels to competitor Hasbro, despite superior growth and near-flawless execution by management over the past several years. With Mattel expected to post earnings per share of $2.36 in 2012, I use a historic price-to-earnings multiple of 14 to reach a 12-month target price of $33, nearly 18% upside from today.

Pepsi ( PEP) -- dividend yield: 3.30%

Coca-Cola ( KO) gets all the press, especially with longtime supporter Warren Buffett consistently adding to his position year after year. Pepsi has encountered growing pains of late, especially in its beverage business, which has struggled to gain traction against Coke. Pepsi's snacks division (Frito-Lay), on the other hand, has maintained a dominant position, with a 39% share of the U.S. snack market, and impressive growth overseas with third-quarter China and India snack sales up 31% and 26%, respectively.

Rumors have swirled surrounding the potential separation of the snacks and beverage divisions, yet management has worked hard to support its "Power of One" mission, claiming the synergies gained from keeping the two are immeasurable.

There have also been grumblings regarding CEO Indra Nooyi and her recent focus on healthier offerings. Investors are concerned that Nooyi may be taking her eye off of the beverages business, due to the continued market-share losses to Coke. The company's Global Nutrition Group aims to double revenue to $30 billion by 2020.

While I can't knock the success of Coca-Cola, I prefer Pepsi's stock over Coke's for a few reasons. One, Coke lacks a diversified business line, including snacks. Two, Pepsi is being valued solely as a beverage concern and deserves a higher multiple based on the growth in its snacks business. Three, even with management defending its stance to keep the company whole, I think that given the surrounding chatter, something is likely to happen, whether a spin-off or some sort of management change. That could only be a good thing for shareholders.

I did a sum-of-the parts analysis on Pepsi and came up with a valuation of $76 (20% upside). I applied a 17 multiple to the consistent Frito Lay snacks business (value of $23 per share), 11 multiple to Quaker Foods (value of $3/share), 13 multiple for Pepsi America Beverage (value of $19 share), 25 multiple to the fast-growth Latin American foods business (value of $10 share), 15 multiple to the European snack and beverage business ($11 per share) and a 21 multiple for the EMEA beverage and snacks business (value of $10 per share).

Here's the full Dividend Stars Portfolio, which offers a dividend yield of 2.77%

Mattel (MAT), dividend yield 3.20%
Pepsi (PEP), dividend yield 3.20%
Exxon Mobil (XOM), dividend yield 2.4%
Novartis (NVS), dividend yield 3.5%
Target (TGT), dividend yield 2.3%
Norfolk Southern (NSC), dividend yield 2.30%
Chubb Corp (CB), dividend yield 2.30%
Microsoft (MSFT), dividend yield 2.90%
Intel (INTC), dividend yield 3.4%
Deere (DE), dividend yield 2.20%
McGraw Hill (MHP), dividend yield 2.3%
Honeywell (HON), dividend yield 2.7%
Procter & Gamble (PG), dividend yield 3.3%

I will be providing further commentary on these companies over the next several weeks, along with commentary on performance and company updates. Today will mark the official "buy"/start date of this portfolio.

To see the 13 stocks in action, you can check out the Dividend Stars Portfolio on Stockpickr.

Here are the criteria for assembling the stocks in the Dividend Select screen:

¿ Dividend yield for the stock must be greater than that of the S&P 500.

¿ Stock must have a "buy" recommendation, based on ratings from TheStreet Ratings.

¿ Financial strength: According to our model, stock must have moderate financial strength and the ability to meet overall debt requirements.

¿ Return on capital: seeking companies with above-average returns over time.

¿ Dividend payout ratio is less than 60%. This will eliminate REITs and MLPs, which are required to pay out a majority of their earnings, and will look for companies that have the capability to invest in the business or new acquisitions.

If you have any questions, comments or suggestions, feel free to message me on Twitter at @bostoncfa

To get more stories like this one, sign-up for TheStreet's free Dividend & Income newsletter. Also, check out our Monthly Dividend Portfolio, which yields 2.71%.

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Equity research manager Chris Stuart, CFA, joined TheStreet Ratings after working as a senior investment analyst with Merrill Lynch covering small-cap equity and alternative investment strategies. Prior to that, Stuart worked for One Beacon Insurance as an actuarial analyst and at H&R Block as a financial adviser. Stuart earned his bachelor's degree in finance from the University of Massachusetts, Amherst. He holds a Chartered Financial Analyst (CFA) designation and is a member of the Boston Security Analysts Society (BSAS) and the CFA Institute.

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