Editor's Note: In each monthly issue of her High-Yield Investing newsletter, experienced analyst Carla Pasternak devotes an article to an in-depth analysis of two high-quality income-producing investment ideas. In her most recent issue she placed the spotlight on two undervalued stocks in out-of-favor industries, and below you'll find an excerpt from that article...

CITIGROUP (C)
It’s a knee-jerk reaction. When rates rise, bank stocks fall. The fear is that bank earnings may be squeezed by the need to offer higher rates on customer deposits than banks will earn on fixed, long-term loans.

Since February, the benchmark bank index has dropped more than -4%, compared with just a -1% fall in the overall market. Bank stocks have declined despite the fact that most firms delivered robust first-quarter results--a sign that investors weren’t looking beyond their wall of worry.

The truth is that not all banks will be hard hit by higher interest rates. In fact, some might even benefit from them. Firms such as Citigroup, the world’s largest financial services provider, don’t depend on interest income for a major portion of their revenue. Instead, sales come from a variety of sources, including fees from investment banking, asset management and insurance. A few weeks ago, for instance, Citigroup bought the mortgage servicing business of Principal Financial Group (PFG).

The timing of that purchase was a stroke of genius. Last year’s record low mortgage rates led to a rash of new loan activity. As rates continue to rise in the months ahead, new financing levels will fall off. However, existing loans will still need to be serviced. The profits Citigroup will generate by servicing long-term loans--especially ones at floating rates--will give the bank a hedge against higher interest rates.

But mortgage servicing is only a small portion of Citigroup’s $18 billion earnings picture. The company is one of the most diversified financial services firms in the world. In fact, Citigroup is a global leader in a full spectrum of financial services, including credit card processing, consumer finance, retail banking, corporate lending, investment banking, brokerage and asset management services--just to name a few. Interest rate changes will have little impact on the firm's host of fee-based businesses. And with services in over a 100 countries throughout the world, Citigroup’s geographical diversification offers yet another moat against the Fed’s attack on the U.S. economy.

The bank has proven itself to be one of the most consistently profitable performers throughout both good times and bad, whether interest rates are moving up or down. Citigroup has churned out average earnings growth of +20% a year for decades. Its return on equity, a key measure of the bank’s ability to generate income from its asset base, has been in an above-average 20+%-range for years. In the most recent quarter, company revenues rose nearly +10% to $15.8 billion thanks to higher loan interest and fees received. Earnings rose +28% to $1.01 a share, helped by expanding margins.

Citigroup has also enriched shareholders with a dividend that has grown at the same clip as earnings. The stock pays a $1.60 dividend (a roughly +3.5% yield) and has increased its payout by an average of +32% in each of the last five years. Citigroup's currently steep dividend yield is more than twice the firm’s own historical average. Meanwhile, its PE of 13 times last year’s earnings and its PEG (PE to growth rate) of less than one times future earnings are both at relatively low levels when compared to the stock’s historical norms. Together, these measures suggest this is an opportune time to capture the stock at undervalued levels and lock in its above-average yield.

PULTE HOMES (PHM)
Leading homebuilders such as Pulte Homes (PHM) have recently posted robust quarterly results, but their stocks are trading about 10% below their March highs. What gives?

The answer is obvious: when interest rates rise, building stocks will suffer--or so says conventional wisdom. In reality, however, higher rates may affect the cost of buying a new home, but the impact on major builders such as Pulte might not be as dramatic as many people think.

Pulte is among the largest residential homebuilders in the country and one of the few that serves all major population groups. With a strong presence in the first-time, move-up, and aging baby-boomer markets, Pulte should benefit from a variety of long-term demographic trends expected to boost demand for new homes in the years ahead.

The company’s performance speaks volumes. Last year, Pulte earned $624 million ($4.90 a share) on $9 billion in revenues. Profits have been growing at a roughly +30% annual clip for years. In addition, a close look at how the firm fared throughout the last two rate-rising periods is especially enlightening. In the high-interest-rate cycles of 1994 and 1999, Pulte’s sales grew +18% and +30%, respectively. Meanwhile, operating profits ballooned +14% in 1994 and +69% in 1999. Past results don’t guarantee future success, but they sure are a testament to the company’s resilience in tough times.

Record earnings, expanding markets, a substantial order backlog and an improved earnings outlook all point to a bright future for Pulte. In the first quarter the firm posted record earnings of $1.02 a share, which represented an increase of +46% from a year ago. What's more, the company's +30% increase in new orders during the quarter proves that Pulte’s move into diversified housing markets is paying off.

Equally important going forward, a record $5.4 billion backlog of 18,000 new home orders should keep the builder busy for the next six months. Encouraged by its growth outlook, management recently raised its earnings guidance for 2004 from $6.00-$6.25 to $7.00-$7.25 a share. That kind of earnings visibility should certainly help the firm build a loyal shareholder base.

Register for Carla Pasternak's High-Yield Investing newsletter today and you'll receive as many as SIX in-depth research reports absolutely FREE!

Of course, no stock is without downside risk, especially a building stock in a rising interest rate environment. Some potential chinks in the firm's armor include debt servicing costs on its seven-year supply of raw land, as well as escalating costs on optioned land to be paid in full a few years down the road. These commitments could squeeze the firm's profit margins going forward, especially if housing demand slows. However, Pulte's excellent operating efficiencies should offset much of the potential decline.

Pulte pays a small dividend of 20 cents a share, which gives the stock a yield of around +0.4%. However, the real payoff here will be the firm's long-term stock performance. With a forward P/E of around 7 based on 2004 projected earnings of $7.05, the stock is now trading at the low end of its historical valuation range and well below both its peers and the market. Pulte may take a short-term hit if interest rates rise aggressively, but in the long run the company is built to last.

ACTION TO TAKE
Both Citigroup and Pulte are bulletproof blue chips with long histories of successful performance. Their diversified operations provide a wide moat of safety in a rising interest rate environment, and both have delivered market-beating returns amidst even the most difficult of times. In addition, both stocks have pulled back in recent months, providing long-term investors with a window of opportunity to build new positions at attractive valuations.

11 Surprising Investment Predictions for 2009 A wind-powered car . . . oil at $160 per barrel . . . a +200% to +300% rebound in shipping stocks... a war fought over water . . . these are just a few of the startling predictions that StreetAuthority Market Advisor has just revealed for 2009.  Each of these developments will trigger explosive profits for investors in the coming year.  Click here to see our full range of forecasts. Income Security of the Month -- January 2009 If you're looking for high yields, monthly payments and unprecedented safety, then you need to learn more about our "Income Security of the Month" for January 2009.  This stable preferred stock has a long track record of paying some of the most dependable dividends in Wall Street history.  It pays a monthly dividend totaling 9.9% annually and has outperformed the S&P 500 by more than +52% over the last year.

The Top Stocks to Own Before Obama Takes Office Whenever Washington decides to help a new industry get off the ground, the investment profits follow in lockstep.  And a small group of 20 to 30 stocks is going to be flooded with so much new government cash that our research team believes a few of them could shoot up 40-to-1 in the next three or four years.  This group of investments was a good bet even before Obama was elected . . . now it's a slam dunk.  Wall Street Meltdown Creates Highest Dividend Yields in a Decade The recent Wall Street crisis has created a once-in-a-lifetime opportunity for investors like you to lock in high yields on safe, low-risk stocks. Yields of 20.2% . . . 22.4% . . . even 33.1%!  Our new special report on the subject shows you SEVEN dividend superstars that can help you rebuild your portfolio.  Click here to get your free copy of the report.