Published monthly, High-Yield Investing is devoted exclusively to income-oriented investments. Each issue presents a wealth of information and timely investment ideas to help you earn a steady income stream from your portfolio.

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1.  MONTHLY MARKET SNAPSHOT

2.  MARKET ANALYSIS

Stocks
The market downswing during the first three weeks of May sent the S&P 500 falling nearly -8% from its March high and had many investors worried that the bull market was over. However, stocks rallied in the final days of May, setting a positive tone for the market. As shown in the table above, the overall market, represented by the basket of 500 stocks in the Standard & Poor’s market index (the S&P 500), closed the month of May slightly ahead of last month and is now up marginally on the year.

Indices of income-oriented stocks tracked the broader market trend, with both the Dow Jones Select Dividend Index and the Dow Jones Equity REIT Index rallying by month end. Dividend stocks, represented by the 50 high-yield stocks in the DJ Select Dividend Index, rallied nearly +5% from their mid-month lows. The DJ Equity REIT index, which contains 95% of all U.S.-listed REITS (real estate investment trusts), had plunged more than -20% by mid-May from its April highs. However, the index then rebounded strongly late in the month, finishing up +2% after all was said and done.

In an attempt to stem the market freefall after Federal Reserve Chairman Alan Greenspan hinted at an interest rate hike, Fed Governor Bernanke announced in mid-May that the markets had already discounted the tightening of interest rates, noting that: “A significant portion of the financial adjustment associated with the tightening cycle may already be behind us.”

As a result of this announcement, interest rate sensitive stocks posted big gains as investors rotated money back into underperforming sectors such as REITs. Also buoying the markets were comments from OPEC, which sent crude prices lower, as well as economic data that allayed concerns of an aggressive tightening of interest rates. Better-than-expected earnings reports also moved the markets higher. A full 75% of S&P 500 components reported first-quarter earnings that topped analyst expectations. In response to this stellar performance, as well as bullish predictions from corporate managers, analysts have now revised second-quarter earnings estimates upward +20%.

Bonds
For the first few weeks of May, in anticipation of a rate hike, bond yields moved up and the spread (please see the yield curve chart above) flattened between the two-year and 10-year Treasury notes. (The yield curve, which shows the yields for bonds of varying maturities, is said to be “flat” when yields are the same for different maturities. A flat yield curve suggests that the market is uncertain and somewhat bearish about our nation's economic outlook.) However, in the last few sessions of the month, investors resumed buying bonds, in part because of reduced concerns about the size of future Fed rate hikes.

During the first half of the month, the yield on the benchmark 10-year Treasury note gained more than +30% from its mid-March lows, as strong economic data raised fears that Fed rate hikes would come sooner rather than later. However, as interest rate jitters lessened we saw a modest rally in the bond market. In the end, yields on the 10-year Treasury rose just +2% on the month. Nevertheless, the yield on the short-term three-month Treasury proved to be the most sensitive to market expectations about Fed policy, rising +10% on the month. High-yield corporate bonds posted better results, with yields advancing just +2% on the month.

Outlook
The end-of-month rally may signal that the markets have reached a short-term bottom and could move higher in June. Encouraging economic news also suggests that the market should find some solid support at recent levels. Strong corporate earnings and rising profit forecasts point to the attractiveness of stocks in what could be a broad-based economic recovery. Income investors who are weighted in dividend-paying stocks should benefit from the improved economic outlook, which may result in higher earnings and therefore increased dividend payments.

3.  SPECIAL REPORT -- FIVE COMPANIES POISED TO GAIN AMID RISING INTEREST RATES

Editor's Note: In this section of the newsletter we take a closer look at a key market trend and offer five specific investment ideas to assist you in taking advantage of that trend.

Threats of rising interest rates and looming inflation are weighing on the market. Interest-rate-sensitive industries, such as housing and banking, have taken a hit in recent trading. In addition, investors have fled dividend-paying stocks, believing that higher interest rates will make bonds and other income-oriented investments (these serve as substitutes for dividend-paying stocks) relatively more attractive going forward. Yet despite Wall Street's recent woes, savvy investors should still have no trouble spotting fresh opportunities in this market.

In fact, it now looks like the market may have overreacted to the possibility of a rate hike. In any case, investors have already priced into most rate-sensitive stocks the negative impact of rising interest rates. Therefore, now may be an excellent time to do some bargain hunting in some of the hardest-hit sectors. In doing so, investors may be able to snap up quality companies at compelling values.

Why Focus on Dividend-Paying Stocks?
Over the long run the prospect of rising interest rates shouldn’t diminish the luster of dividend-paying stocks. The average yield for S&P 500 component stocks now sits at +2%. That may not sound like much, but compared to the average money market rate of about +1.3%, it doesn’t look too bad. Although stocks carry greater risk than Treasuries and money market accounts, it's important to note that almost all of the companies we profile in this newsletter sport yields that far exceed that +2% average.

Remember, too, that recent tax law changes have reduced tax rates on most dividend income to 15%. In contrast, interest income on Treasuries and money market funds is still taxed as ordinary income, up to 38.6%. Because of this, the new tax laws let you keep a bigger bite of the dividends earned on income-paying stocks.

Yes, you can earn +4.67% on the benchmark ten-year Treasury note and even better on other bonds right now. However, if you invest here you'll also risk losing a big portion of your capital as interest rates rise (rising rates tend to put downward pressure on bond prices). By contrast, if you invest in quality income stocks, dividends are only a portion of the total returns you'll enjoy. Many stable blue-chip companies are performing extremely well right now thanks to the booming U.S. economy. As such, these stocks could continue to deliver healthy capital gains in the months ahead (in addition to dividends).

Far from spelling doom to dividend-payers, a Fed rate hike may actually be a positive signal of higher dividend payouts ahead. Greenspan only raises interest rates when the Fed sees a need to moderate a strengthening economy. Economic growth typically boosts corporate profits, which can translate into enhanced dividends for shareholders.

A History of Impressive Returns
Contrary to the popular image of dividend-payers as stodgy, slow growth companies, history proves that dividend payers outperform non-payers over time. Studies have shown that dividend-paying stocks have outperformed non-payers for over three decades since 1970. Their stock prices were also 10% less volatile, meaning they could be counted on to deliver steady returns throughout both good times and bad. And according to the latest statistics from Standard & Poor's, dividend-paying stocks have continued to outpace non-payers so far this year. Through the end of April, dividend payers were up +2%, compared to a loss of -1.5% for non-payers.

Historically, dividends have accounted for an enormous chunk of the S&P 500's total return. In fact, over the past 75 years dividends have contributed over 40% of the total returns of the S&P 500. The index's average annual return from 1926 through 2003 was +10.4%, of which +4.3% came from dividends, according to an Ibbotson Associates study.

Stability in an Uncertain Environment
But not all income stocks will benefit equally in a higher-interest-rate environment. With this in mind, investors may want to rebalance their portfolio now to take advantage of these new economic realities. In particular, now might be a good time to take a defensive posture and gain greater exposure to stocks that typically stand up well when rates rise and the market totters. In market downturns, these stocks tend to be safe havens for the income investor.

Which stocks are set to deliver these stable returns? Well, history has shown that healthcare, consumer staples and defense stocks generally outperform the broader market during tough times. This year has proven to be no exception to that rule, as these sectors have been riding high while interest rate jitters spook the markets. Pharmaceutical giants Johnson and Johnson (JNJ, $55.71) and Teva Pharmaceuticals (TEVA, $66.17) are our top picks in the healthcare sector. Meanwhile, global leaders Procter & Gamble (PG, $107.82) and Sara Lee (SLE, $22.90) are our favorites for consumer staples. And finally, premier defense contractor General Dynamics (GD, $95.63) is our top-ranking stock in that industry. All five stocks are unbeatable for safety, growth, and high dividend income.

Healthcare
Regardless of what is happening with the overall economy, demand for healthcare tends to stay fairly constant over time. Because of this, healthcare stocks usually make excellent defensive plays. After the Fed's last rate hike, for example, healthcare stocks actually jumped +5% and major pharmaceuticals gained even more ground.

Typically immune to rate increases, healthcare stocks are also seeing a boost from favorable demographic trends right now. Aging baby boomers are starting to spur growing demand for drug treatments and medical care. This sector has seen a remarkable rebound since mid-2002, and we believe this rally will continue throughout the rest of 2004.

JOHNSON AND JOHNSON (JNJ, $55.71) -- The world's largest healthcare company, Johnson and Johnson is well known for such household names as Band-Aids, Johnson's Baby Shampoo and Tylenol. Established more than a century ago, the company is the oldest and most diversified pharmaceutical firm in the world. Its diverse product line and worldwide marketing presence provide a stable revenue base with large growth potential.

As a pharmaceutical firm, the company faces a number of important challenges. Among these are patent expirations, generic drug competition and other product-specific risks. Thanks to its diverse revenue stream, however, JNJ tends to hold up well year-in and year-out despite these risks. After all, when the firm faces problems in one of its business lines, these are usually more than offset by strong sales at its other diverse units. JNJ derives more than half of its revenue, or 53%, from medical devices, non-prescription drugs and healthcare products. Pharmaceuticals account for the balance. About 60% of the firm's sales come from the United States, with the remainder coming from various international markets.

The company pays a generous $1.14 annual dividend, which equates to a nearly +2% yield based on recent prices. In addition, the firm has been increasing its dividend payments for more than 40 years. In recent action, management has boosted the company's dividend payments by a remarkable +14% per year over the past five years--a growth rate well above its industry rivals and twice that of the average firm in the S&P 500.

If any company deserves the title of “blue-chip,” it’s Johnson & Johnson. The firm has delivered over 70 consecutive years of sales increases and more than two decades of double-digit earnings growth. In the past five years, JNJ has seen sales rise by +11% and earnings soar by nearly +20% thanks to consistently stronger operating margins.

Due in large part to its stable business lines and substantial cash reserves, Johnson & Johnson is one of a select group of companies with an "AAA" credit rating. The company holds more than $3.7 billion in cash, even after completing several acquisitions. Its ability to generate cash--at a +23% clip over the past five years--has enabled JNJ to finance internal growth while also rewarding shareholders with higher dividend payments.

Johnson & Johnson's impressive record of earnings growth and dividend increases is set to continue for years to come. Given its substantial cash reserves, the company should be able to not only replenish its drug pipeline through acquisitions, but also continue to plow back billions of dollars into R&D. This will help JNJ fuel above-average growth throughout 2004 and beyond. In fact, analysts expect the company to post +13% annual earnings growth over the next five years--a rate that easily exceeds that of its industry peers.

Despite an above-average growth rate and favorable future projections, Wall Street is now valuing Johnson & Johnson at a slight discount relative to its industry peers and the S&P 500. At current prices, JNJ is an attractive stock that offers the long-term investor a solid income yield and the potential for strong capital appreciation no matter what happens to the overall market.

Johnson & Johnson (JNJ, $55.71)
Market Capitalization (billion):  $165.3
2001 Revenue (billion):  $32.3
2002 Revenue (billion):  $36.3
2003 Revenue (billion):  $41.8
2001 EPS:  $1.83
2002 EPS:  $2.16
2003 EPS:  $2.40
2004 EPS:  $3.00 (est.)
2005 EPS:  $3.29 (est.)
Annual Dividend Payment:  $1.14
Dividend Yield:  +2.04%
Five-Year Dividend Growth:  +13.8%
Five-Year Expected EPS Growth:  +13%
P/E on 2004 EPS estimate:  18
Institutions own 62.6% of the firm's outstanding shares
52-week range:  $48.05 to $56.39
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TEVA PHARMACEUTICALS (TEVA, $66.17) -- Our second healthcare sector favorite, Teva Pharmaceuticals, is the undisputed leader in the rapidly growing generic drug market.

Generic drugs are the chemical equivalent of brand-name drugs, but sell at drastically reduced prices. Under current regulations, generic drugs can be marketed only after patents on the equivalent branded drugs have expired. Generic drugs already account for nearly 50% of all prescription sales in the U.S., and that percentage is set to increase in the years ahead as some $50 billion in U.S. branded drugs lose patent protection between now and 2007. Most of these drugs are likely to be replaced by generics, and as the world's largest generic drugmaker, Teva is well positioned to capture a large share of this burgeoning market.

The Israeli-based pharmaceutical giant operates over 20 manufacturing plants around the world, boasts a diverse portfolio of about 150 generic products, and is one of the world’s largest suppliers of bulk pharmaceutical chemicals to drug manufacturers. Pharmaceuticals account for some 90% of sales, with the balance from chemical ingredients, hospital supplies and veterinary products.

Through its U.S. subsidiary, Teva makes generic versions of brand-name antibiotics, heart drugs, heartburn medications, and such well-known blockbusters as antidepressant Prozac and cholesterol drug Mevacor. Teva also makes a few patented brand-name drugs, including Copaxone--an injectable treatment for multiple sclerosis. The blockbuster drug, which accounts for about 20% of Teva's sales, has captured a 30% share of the U.S. multiple sclerosis market and 15% of the worldwide market. Copaxone is protected by U.S. patent for another decade.

Although the firm only pays a small annual dividend, it has increased its payout by over +30% in the past five years. With a payout of 39 cents a share, the stock now yields +0.6%. However, that yield is likely to increase sharply in the years ahead as management continues to focus on returning value to shareholders. In the meantime, the stock should deliver solid capital appreciation and should hold up well regardless of overall market conditions.

Teva's financial track record is outstanding. Despite its large size, the company has managed to deliver annual sales growth of +25% and sustain a remarkable +50% earnings growth rate for the past three years. Robust Copaxone sales and the rapid expansion of generic pharmaceutical markets in both the U.S. and Europe should help the company sustain its recent momentum for the foreseeable future.

Teva delivered a nearly +40% gain in first-quarter sales earlier this year. Excluding one-time charges mainly related to the company's recent acquisition of Biotech firm Sicor, earnings for the quarter were 64 cents a share, up +28% from a year ago. Teva's management is calling for earnings growth of +27% this year and another +16% next year.

At 20 times next year’s estimated earnings, Teva's stock commands a slight premium to that of its peers. However, given its industry-leading position, stable revenue base and projected long-term growth rate of +23% (twice that of its peers and the S&P 500), we believe the company deserves this premium valuation. In addition, when looked at on a PEG basis (you can calculate a firm's PEG ratio by taking its PE multiple and dividing that figure by the company's projected growth), the stock is actually undervalued relative to the industry and the overall market. Teva's PEG of less than 1 (PE of 20 divided by +23% growth) is well below the average PEG of 1.5 sported by both the industry and the S&P 500. Based on this metric, Teva appears to be a downright bargain.

With worldwide dominance in a fast-growing market and a dynamite pipeline of new products, we believe Teva is an attractive defensive stock that will continue to deliver double-digit returns no matter which direction the overall market heads from here.

Teva Pharmaceuticals (TEVA, $66.17)
Market Capitalization (billion):  $19.7
2001 Revenue (billion):  $2.1
2002 Revenue (billion):  $3.6
2003 Revenue (billion):  $3.3
2001 EPS:  $1.01
2002 EPS:  $2.19
2003 EPS:  $2.40
2004 EPS:  $2.71 (est.)
2005 EPS:  $3.20 (est.)
Annual Dividend Payment:  $0.39
Dividend Yield:  +0.59%
Five-Year Dividend Growth:  +33.5%
Five-Year Expected EPS Growth:  +23%
P/E on 2004 EPS estimate:  24
Institutions own 59% of the firm's outstanding shares
52-week range:  $48.42 to $67.36
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Consumer Staples
Consumer staples, such as food and household products, usually hold up well when rates rise and the equity markets fall. After all, in good markets and bad, people still need to eat and to use shampoo, cleaners and other household items. This industry group has been moving ahead in recent months as many major institutional investors position themselves defensively. Despite this, however, industry leaders Procter and Gamble (PG) and Sara Lee (SLE) are still trading at reasonable valuations. Both stocks also offer above-average dividend yields, making them worth a closer look for income-oriented investors.

PROCTER & GAMBLE (PG, $107.82) -- Procter & Gamble is the world’s largest consumer products company. This $150 billion behemoth markets over 300 products throughout the world, with fully half its sales coming from international markets. Its famous brands of household names include Cheer, Pampers, Head & Shoulders, Crest, Scope, Pepto-Bismol, and Joy, to name just a few. Bounty paper towels, Charmin toilet paper, Tide detergent, Pantene shampoo, Iams pet food, Cover Girl cosmetics, Folgers coffee, and Pringles potato chips are among the 13 best-selling brands that account for half the company’s revenue.

Founded in 1837 as a soap and candle maker, Proctor & Gamble has been paying dividends every year for the past 114 years. Not only that, the firm has increased its payout for 48 consecutive years. The stock currently offers a generous annual dividend of $2.00 a share, which equates to a +1.8% yield based on recent stock prices.

Procter & Gamble is a classic turnaround success story. Company growth ground to a complete halt in the late 1990s. At that point in time, revenues were flat and the firm's famous brands were losing market share. Management had promised Wall Street that by 2006 it would double sales to $70 billion. Back then, with sales inching along at a roughly +2% clip each year, that seemed like an impossible target. In fact, one analyst had estimated it would take the company at least quarter-century to hit that mark! However, with this year’s revenues projected to come in above $50 billion and an expected +8% growth rate next year, that $70-billion target now appears to be within striking distance.

Procter & Gamble's shares have been on a tear lately, as the firm has continued to surprise Wall Street by posting solid sales and earnings figures. Thanks to rising profit margins, company earnings are forecast to advance +25% to $4.62 per share this year. With cash reserves of nearly $6 billion and free cash flow of about $6 billion already this year, the company can more than cover its somewhat hefty $18 billion debt. With a debt-to-equity ratio of less than 1, the firm's financial leverage is well below the industry average.

The consumer products maker is a premier defensive stock that should hold up well in both good times and bad. Procter & Gamble delivered strong financial results despite facing a sluggish economy in 2000-2002, and the firm is poised to continue that growth streak in the years ahead. Company sales should also benefit from management's smart strategic moves into the high margin beauty-care market with its 2002 purchase of Clairol and its 2003 acquisition of German-based Wella. Procter & Gamble has also used a number of recent deals to stake its position in the rapidly emerging Chinese markets.

At 23 times next year’s earnings, the shares are trading at a reasonable valuation relative to large-cap rivals such as Colgate-Palmolive (CL, $57.20). Given its solid performance and exciting growth prospects, PG is attractively valued and the shares have room to move.

Procter & Gamble (PG, $107.82)
Market Capitalization (billion):  $138.7
2001 Revenue (billion):  $39.2
2002 Revenue (billion):  $40.2
2003 Revenue (billion):  $43.4
2001 EPS:  $2.06
2002 EPS:  $3.10
2003 EPS:  $3.69
2004 EPS:  $4.62 (est.)
2005 EPS:  $5.11 (est.)
Annual Dividend Payment:  $2.00
Dividend Yield:  +1.84%
Five-Year Dividend Growth:  +10.2%
Five-Year Expected EPS Growth:  +11%
P/E on 2004 EPS estimate:  23
Institutions own 59% of the firm's outstanding shares
52-week range:  $86.51 to $108.85
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SARA LEE (SLE, $22.90) -- Consumer products giant Sara Lee seems to have a finger in just about every pie, from Ball Park franks and Sara Lee cheesecakes to Playtex lingerie and Hanes underwear to Earthgrains breads and Kiwi shoe polish. The firm sells its diverse lineup of food, household, and underwear products in more than 200 countries around the world. What's more, the company is a world leader in many of the markets in which it operates. For example, Sara Lee holds the #1 market share in the U.S. underwear market, is the top brand worldwide for shoe care, and is the second-largest market share holder in the deli and baked goods area.

The company has been rewarding shareholders with fat dividend payments since 1946. The firm's 75-cent annual dividend equates to an above-average yield of +3% based on recent share prices. In addition, management has boosted the firm's dividend payment by an average of +6.5% a year over the past five years. Last year, management showed its commitment to its shareholders by boosting its dividend +13%.

This $20 billion powerhouse is a veritable cash machine. Every year the company throws off more than enough free cash flow to cover its dividend payments, pay down debt and fuel future growth. In the past year alone Sara Lee generated nearly $1.35 billion of free cash flow.

Despite its ability to churn out cash flow year after year, the stock is only now coming back into favor on Wall Street. Company growth has been slow over the past few years as markets for many of its consumer products matured and margins declined. Sara Lee's sales have grown at a less than +1% clip over the past five years. Meanwhile, earnings have eked out a meager +6% gain over the same period. The firm's underwear segment has been particularly hard-hit due in large part to the trend toward casual dress, which cut hosiery sales in half. Meanwhile, the combined effects of rising cotton costs and heightened competition have contributed to reduced profit margins.

Although times have been tough in recent years, Sara Lee’s fortunes are now turning around. Sales gained +4% last year and earnings grew by +20% thanks to stronger margins resulting from the company’s cost-cutting efforts. The firm's earnings continued their upward run in the most recent quarter, spiking +40% over the same period a year ago.

Looking ahead, profits are expected to grow another +6% in fiscal 2004 and +7% in 2005. The firm's projected five-year earnings growth rate now sits at a fairly solid +7%.

With a PE of 14 compared versus the industry’s 17, the stock is a bargain. Although its long-term growth rate is slightly under the industry norm, the company has proven to be a steady, reliable income generator for decades. With its substantial cash horde and rock-solid reputation, some analysts also see the firm as a potential takeover target. Regardless of whether or not the firm eventually gets bought out, long-term investors who wait for the company to complete its turnaround should be well rewarded for their patience. In the meantime, they'll earn a generous dividend just for holding the stock.

Sara Lee (SLE, $22.90)
Market Capitalization (billion):  $18.2
2001 Revenue (billion):  $16.6
2002 Revenue (billion):  $17.6
2003 Revenue (billion):  $18.3
2001 EPS:  $1.91
2002 EPS:  $1.24
2003 EPS:  $1.50
2004 EPS:  $1.59 (est.)
2005 EPS:  $1.70 (est.)
Annual Dividend Payment:  $0.75
Dividend Yield:  +3.23%
Five-Year Dividend Growth:  +6.5%
Five-Year Expected EPS Growth:  +7%
P/E on 2004 EPS estimate:  14
Institutions own 60% of the firm's outstanding shares
52-week range:  $17.41 to $23.75
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Defense
The threat of terrorist attacks is still very much alive and geopolitical tensions continue to mount. With this as a backdrop, the U.S. continues to invest heavily in defense. Analysts estimate that the government’s defense budget will rise more than +6% a year over the next four years. As the nation's leading defense contractor, General Dynamics is expected to be a prime beneficiary of this increase in defense spending.

GENERAL DYNAMICS (GD, $95.63) -- In this post-September 11th world, defense contractors such as General Dynamics are in the right place at the right time. The stock has returned a whopping +46.5% throughout the past year compared to the S&P 500’s +28.1%.

But General Dynamics is not just in the defense market. Its flagship Gulfstream business jet also makes General Dynamics the world's #1 long-range jet maker. Demand for the firm's jets remained stable even during the economic slowdown from 2000-2003. Its leading position in this market makes General Dynamics a solid defensive stock that is poised to profit in any economic cycle.

In addition to its push into commercial aerospace (30% of revenue), the company’s three other businesses each contribute about equally to the remaining 70% of revenue. The firm's marine systems unit is the Pentagon’s second largest military shipbuilder after Northrop Grumman (NOC, $103.13). Meanwhile, its combat systems division makes armored vehicles and is the U.S. Army’s only tank-maker. And finally, General Dynamics' information systems unit is a major provider of computer technology and electronics to the U.S. military.

This 50-year-old company has been paying dividends at increasing rates since 1979. Its annual $1.44 payment, which equates to a +1.5% yield based on recent share prices, represents less than 25% of this year’s expected earnings. With that in mind, the firm should have plenty of room to continue to boost its dividends in the years ahead. In addition, future dividend gains will be fueled by enormous recent increases in company earnings.

General Dynamics has seen its ups and downs over the years. However, business has been mostly positive throughout the past decade. In the late 1990s management steadily ramped up the firm's presence in a number of key markets through a series of strategic acquisitions. Despite these acquisitions, the firm maintains a solid balance sheet with a below-average debt-to-equity ratio of 0.6. In addition, the company has delivered an above-average return on equity of +25% for over a decade.

Thanks to a number of recent restructuring efforts, General Dynamics has dramatically improved shareholder returns in recent years. Sales of $18 billion so far this year have grown a remarkable +20% a year since 1998. The firm's recent growth is being fueled mainly by its high-margin Gulfstream business and heightened demand for military information technology.

Profits and cash flow are also growing at double-digit rates and are expected to do so over the next five years. Although the firm's Gulfstream jet unit underperformed last year, the company recently introduced a new line of business jets with a new pricing structure. The results of this change have been overwhelmingly positive so far, and the firm is now showing a backlog of orders for its aerospace unit. In addition, the increasing affordability of business jets (through new share ownership schemes) points to a very favorable long-term outlook for this unit.

With estimated earnings of $5.81 per share this year, General Dynamics should show an increase of +16% over last year’s EPS results. The company also continues to churn out massive amounts of free cash flow. Last year’s $1.5 billion was among the highest in the industry.

The stock has risen sharply in the past year on expectations that General Dynamics will be a prime beneficiary of increases in U.S. government defense spending. However, at less than 16 times next year’s earnings, the stock is still trading at a discount to comparable defense contractors.

Thanks to a low price-earnings multiple and a robust +12% long-term projected growth rate, the stock’s 1.34 PEG ratio (PE divided by long-term growth rate) is well below average for both the industry and the S&P 500. These metrics underscore the fact that General Dynamics is an exemplary company that investors can still scoop up at a reasonable price.

General Dynamics (GD, $95.63)
Market Capitalization (billion):  $19.0
2001 Revenue (billion):  $12.1
2002 Revenue (billion):  $13.8
2003 Revenue (billion):  $16.6
2001 EPS:  $4.64
2002 EPS:  $5.18
2003 EPS:  $5.01
2004 EPS:  $5.81 (est.)
2005 EPS:  $6.42 (est.)
Annual Dividend Payment:  $1.44
Dividend Yield:  +1.5%
Five-Year Dividend Growth : +7.8%
Five-Year Expected EPS Growth:  +12%
P/E on 2004 EPS estimate:  16
Institutions own 75% of the firm's outstanding shares
52-week range:  $64.32 to $97.00
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ACTION TO TAKE: The markets have come under some severe selling pressure in recent months on fears of rising interest rates. With this in mind, now might be a good time to reposition your portfolio into more solid, stable companies that should remain largely immune to market downturns. Johnson and Johnson, Teva Pharmaceuticals, Procter and Gamble, Sara Lee and General Dynamics all operate in sectors that typically perform well in both good markets and bad. In addition to the potential for share price appreciation, you can also count on all of these stocks to deliver solid dividend income for years to come.

4.  IN-DEPTH PROFILES -- ROYAL DUTCH/SHELL (RD), KRAFT FOODS (KFT)

Editor's Note: Each month we devote this section of the newsletter to an analysis of two income-producing investment ideas that can help you generate above-average returns over the long haul. 

In today's issue we're going to focus our attention on two beaten-down blue-chip companies. Both of these companies are turning things around and are still trading at compelling prices.

ROYAL DUTCH PETROLEUM (RD, $50.09) -- Oil stocks provide the perfect hedge against rising oil prices. The oil index, now at a 10-year record high, reflects expectations of a growing demand for oil in the face of diminishing supply. Among the oil giants, Royal Dutch Petroleum is one of the highest yielding and most attractively valued in the industry.

The Royal Dutch/Shell Group is the world’s third largest oil company. The conglomerate operates in 145 countries in three business segments. Oil and gas accounts for 90% of revenue, chemicals another 8%, and power generation the remaining 2%. Royal Dutch/Shell is owned by holding companies Royal Dutch Petroleum in The Netherlands (60% ownership) and Shell Transport & Trading (SC, $43.78) in the United Kingdom (40% ownership). Neither partner has its own operations. Royal Dutch/Shell trades as Royal Dutch Petroleum (RD) on the New York Stock Exchange.

The stock pays an above-average annual dividend of $2.11, which equates to a +4.2% yield based on recent prices. The firm has been boosting its dividends on a regular basis since 1947, and last year’s increase came in at a hefty +23%. In more recent action, management has shown its commitment to shareholders by announcing that future dividend increases will at least match the level of inflation.

Royal Dutch/Shell's shares came under some intense selling pressure earlier this year after management revealed that it had overstated its global energy reserves. Investors responded to the news by slashing the firm's share price and forcing the ouster of top management. For value-oriented income investors, the recent flap has created an opportunity to buy a high-quality, high-yield company at a discount to its peers.

Although the firm's reputation was indeed tarnished by this recent setback, Royal Dutch/Shell's long-term outlook remains fundamentally sound. This 114-year old bellwether boasts a long history of profitability. Earnings jumped +36% last year to $3.68 a share, and the firm continues to generate strong cash flow. Both of these items should help RD support its dividends for years to come. Not only that, with a record $22 billion cash flow last year, management has been able to pare the company's debt, invest in capital spending, raise the firm's dividend payout and propose a $2-billion share buyback program.

Looking ahead to the rest of the year, Royal/Dutch Shell's earnings are expected to grow at a +5% clip to $3.88 per share thanks to record high oil and gas prices. Next year, earnings could temporarily taper off in response to weaker commodity prices and decreased production due to the company’s low reserve base. Overall, though, Royal Dutch/Shell should continue to grow at a healthy +10% annual clip in the years ahead, slightly better than the industry average. And thanks to its status as a highly diversified integrated oil giant, the firm's financial results should steadily improve regardless of volatile commodity price swings. With all of these factors in mind, the stock remains a solid choice for defensive, income-oriented investors.

Royal Dutch (RD, $50.09)
Market Capitalization (billion):  $101.8
2001 Revenue (billion):  $81.1
2002 Revenue (billion):  $100.0
2003 Revenue (billion):  $121.2
2001 EPS:  $3.07
2002 EPS:  $2.71
2003 EPS:  $3.68
2004 EPS:  $3.88 (est.)
2005 EPS:  $3.58 (est.)
Annual Dividend Payment:  $2.11
Dividend Yield:  +4.18%
Five-Year Dividend Growth:  +2.0%
Five-Year Expected EPS Growth:  +10%
P/E on 2004 EPS estimate:  13
Institutions own 15% of the firm's outstanding shares
52-week range:  $42.84 to $54.00

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KRAFT FOODS (KFT, $29.86) -- Although this food giant has faced some recent setbacks, Kraft remains a solid blue-chip company that should perform well over the long haul. Management has a well-devised turnaround plan in place and investors are already starting to see positive results. We like this stock not only for its superior reputation, but also due to the fact that it operates in a bulletproof industry that should perform well in any economic environment. For the longer-term income investor, we believe Kraft could deliver above-average returns.

Kraft is the biggest food and beverage company in the United States and the second largest in the world. Many of its well-known products rank #1 in market share worldwide, and just about every household in the U.S. (99.6%) uses Kraft products. The company’s top-selling brands include Nabisco cookies and crackers, as well as Kraft, the world’s leading brand of cheese.

The firm's other billion-dollar brands include Oscar Meyer, the leading U.S. processed meats brand, and Maxwell House coffee. Meanwhile, the company's Philadelphia brand is the world’s leading cream cheese and Post is the nation's third-largest cereal maker. The 102-year old company (formerly General Foods) went public in 2001, but is currently 84% owned by Altria Group (MO, $47.97).

The company pays a 72-cent dividend, which at current prices gives the stock a +2.4% yield. Kraft boosted its dividend payment +18% last year, and the stock’s relatively low 27% payout ratio leaves plenty of room for further increases down the road.

Kraft is a classic turnaround story with a rock solid reputation as a steady grower. Its past five-year growth rate is a strong +12%, but in the last few years earnings have slowed in response to changing market trends. However, management has now set an effective plan in motion to revive the company, and we fully expect to see Kraft return to steady earnings growth by 2005.

On the international front, the firm's expansion into emerging markets such as China, Russia, and Brazil is already beginning to bear fruit. Sales in international markets grew +10.5% last year, which compares favorably to just +2% growth in North America. In an effort to improve margins and generate annual cost savings of at least $400 million by 2006, management recently initiated an aggressive $1.2 billion restructuring effort. The move will result in 6,000 job cuts and the closing of 20 plants worldwide over the next three years. Company earnings are expected to increase a healthy +6% next year thanks in large part to these cost-saving efforts.

Early results of the firm's restructuring plan are encouraging, and given Kraft’s reputation as the world’s preeminent food company, the odds of success are stacked in its favor. Going forward, the company should have no trouble meeting expectations for a five-year earnings growth rate of +8%. That should return some luster to the stock, which is now attractively valued at about 15 times earnings. Rumors of an impending spin-off by parent Altria could also spark a rally in the stock.

Kraft (KFT, $29.86)
Market Capitalization (billion):  $51.4
2001 Revenue (billion):  $29.2
2002 Revenue (billion):  $29.7
2003 Revenue (billion):  $31.0
2001 EPS:  $1.16
2002 EPS:  $1.96
2003 EPS:  $2.01
2004 EPS:  $1.92 (est.)
2005 EPS:  $2.04 (est.)
Annual Dividend Payment:  $0.72
Dividend Yield:  +2.4%
Five-Year Dividend Growth:  N/A
Five-Year Expected EPS Growth:  +8%
P/E on 2004 EPS estimate:  15
Institutions own 13% of the firm's outstanding shares
52-week range:  $27.60 to $34.70

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ACTION TO TAKE: The two value stocks we profiled above--Royal Dutch/Shell and Kraft--both have significant upside potential from today's levels. Each firm enjoys at least one major competitive advantage over the competition, and this edge will help support its continued growth over the long haul. Although both companies have faced recent setbacks, these near-term challenges afford the value investor an attractive buying opportunity. Both companies have the resources to turn their fortunes around and provide meaningful long-term shareholder value.

Editor's Note: In sections 5-7 below we take a closer look at our three model portfolios. In doing so, we summarize how each portfolio has performed, explain any recent changes we've made, and also look at current events that could have a material impact on these investments. Every month we also present you with a fresh list of possible candidates that we're considering adding to our portfolios.

5.  INCOME ANCHORS PORTFOLIO

Our Income Anchors Portfolio contains stocks with above-average dividend yields. And since dividend payments are by no means guaranteed, we only invest in financially solid companies that should have the ability to continue paying sizable dividends in the years ahead.

Recent Events:

Cedar Fair (FUN, $32.66) -- Cedar Fair recently announced 2004 first-quarter results. As an operator of seasonal resort facilities, results for the January through March period are typically nothing to write home about here. Company revenues grew from $21.5 million to $23.2 million, and the firm managed to reduce its net loss for the winter months to 59 cents a share, down from 62 cents a year ago. As the summer season begins, park attendance will improve and so will profits. Although the firm's operating performance is affected by seasonal considerations, the stock has been performing well throughout the year. Much of that performance has to do with the partnership’s quarterly distributions, which management has raised 13 times in the past decade. The firm's $1.80 annual dividend gives the stock a very impressive +5.6% yield based on recent prices. We will be watching this stock closely as it moves into its seasonal peak period. Rating: Hold

Gillette (G, $43.09) -- Gillette’s first-quarter results were razor sharp. Earnings rose +43% to 37 cents a share on a +13% jump in sales to $2.24 billion. Profits also benefited from recent cost-cutting measures. Razor sales rose +16% to $1.04 billion. Its worldwide market share in razors held strong at 73%, and actually expanded 10% for its new razor products. The shares hit a fresh 52-week high on the news. However, looking ahead management indicated that it expects growth to moderate in the second half of the year. As such, we intend to monitor this stock closely in the coming months. Rating: Hold

Johnson & Johnson (JNJ, $55.71) -- The pharmaceutical giant posted a strong first quarter. Sales for its Cypher drug have remained strong, and the company's consumer and pharmaceutical units made healthy gains. Earnings rose +20% to 83 cents a share on an +18% increase in revenues. The company also raised its earnings guidance for 2004 to a full $3 a share. While Johnson & Johnson is a proven performer with a solid yield, we remain ever alert to the fact that healthcare is a highly competitive industry. Rating: Hold

Procter & Gamble (PG, $107.82) -- Procter & Gamble’s third-quarter results are proof positive that mature, stable, dividend-paying companies can still pack a good punch. Third-quarter sales jumped +22% to $13 billion and earnings rose +20% to $1.09 a share. Sales volumes increased in all regions and in 19 of the firm's top 20 brands. Cash flow grew +23%, and with capital expenditures at only 4% of sales, the firm has already generated free cash flow of more than $5.6 billion this year. This quarter’s blowout results were helped by currency exchange rates, which accounted for 5% of the sales increase. Cost cutting also contributed to the company’s bottom line. However, favorable exchange rates cannot be expected to continue indefinitely and competitive pricing pressures may ultimately affect profitability. Given these concerns, we will continue to keep an eye on Procter & Gamble. Rating: Hold

Teva Pharmaceuticals (TEVA, $66.17) -- Teva’s first-quarter sales rose +39% thanks to a number of new generic products, higher global sales of its Copaxone multiple sclerosis treatment and consolidation of revenue from Sicor, a recently acquired Biotech firm. The company reported a net loss of $1.44 a share, but excluding one-time charges mainly related to the Sicor acquisition, profits rose +28% to 64 cents a share. The shares, which are now trading near their 52-week highs, rose over +4% on the earnings release as the company upped its guidance for 2004. With the stock trading at about 24 times this year’s expected earnings, we will be watching closely to see if it moves into the overvalued range. Rating: Hold

Stocks to Watch:
Below you'll find a brief description of companies that we're now considering as possible new additions to our Income Anchors Portfolio. We're following each of these stocks closely and may add a few of them to this portfolio when their risk/reward profiles meet our stringent criteria. Here’s why each stock is worth following:

Avon Products (AVP, $88.66) -- Avon’s business model follows the traditional distribution network of personal service through the Avon Lady. The stock has attracted buying interest lately, due in large part to a pickup in international sales and strengthening profits. And in a move to broaden its market appeal, the company has signed cross-cultural actor Salma Hayek to promote its products. In addition to its growth potential, the firm offers a solid $1.12 dividend (+1.3% yield).

ExxonMobil (XOM, $43.25) -- ExxonMobil is the world’s largest and most profitable oil company. Its revenues and profits tend to be somewhat cyclical because of the firm's dependence on oil prices. And with oil prices now near record highs, its shares are trading near the top of their 52-week trading range. However, the firm's price-earnings ratio of about 15 is near the low end of its five-year range between 13 and 42. XOM also offers a solid $1.08 dividend payment (+2.5% yield).

General Dynamics (GD, $95.63) -- Defense companies like General Dynamics are well suited for today's uncertain times. About half of the company’s revenues come from the Pentagon, which is widely anticipated to increase its military spending over the next few years. Investors have bid the shares up recently, so we're going to wait for a pullback before we add this stock to our portfolio.

6.  HIGH-YIELD REITS PORTFOLIO

Our High-Yield REITS Portfolio contains a select group of high-yielding real estate investment trusts (REITs) that operate primarily in the property and mortgage markets.

Recent Events:

Rayonier (RYN, $41.37) -- Forest products giant Rayonier recently reported strong first-quarter results thanks to stronger land sales, higher U.S. timber prices and volumes, and higher prices for specialty fibers and lumber. However, the market had already priced the news into the stock. As a result, the shares fell several percent following the announcement in late April. We viewed that pullback as an opportunity to add the stock to our High-Yield REITs Portfolio at an attractive price, which we did on April 30th. Rating: Buy

Stocks to Watch:
Below you'll find a brief description of companies that we're now considering as possible new additions to our High-Yield REITs Portfolio. We're following each of these stocks closely and may add a few of them to this portfolio when their risk/reward profiles meet our stringent criteria. Here’s why each stock is worth following:

Apartment Investment and Management (AIV, $28.88) -- Apartment Investment and Management is one of the nation's largest apartment REITs. The company recently reported a drop in first-quarter funds from operations (FFO), a key industry measure, due to a decline in occupancy. AIV expects to post FFO of $2.75 to $3.00 per share this year, down from its prior forecast of $2.85 to $3.20 per share. The company continues to grow through acquisitions and redevelopment. We are watching for a turnaround in occupancy and rental rates here, which we expect will eventually take hold as the economy improves.

Equity Office Properties (EOP, $26.95) -- Interest rate jitters have been weighing on shares of Equity Office Properties. The company recently reported a drop in first-quarter funds from operations (FFO), a key measure of real estate investment trust performance, because of a decline in occupancy. We believe this firm is well positioned to benefit when the commercial real estate market strengthens. This should happen in the coming year as a stronger economy leads to higher employment.

Equity Residential (EQR, $29.44) -- Equity Residential is the world's largest publicly traded apartment REIT. The company is well positioned in the fast-growing suburban apartment market, which serves middle-income customers who can't afford to buy a home. As interest rates rise and job growth improves, demand for apartment rentals should increase and EQR should benefit.

7.  LOW-RISK FUNDS PORTFOLIO

Our Low-Risk Funds portfolio includes a mixture of income-oriented-ETFs (exchange-traded funds) and a variety of outperforming mutual funds that can help you not only generate income, but also diversify your portfolio.

Interest rate worries and a bearish stock market have placed downward pressure on most income-oriented ETFs and funds that we track. As a result, we have yet to add any funds to this portfolio. Going forward, we will continue to keep a close watch on this area and will add a fresh batch of new funds to this portfolio as soon as market conditions improve.

Funds to Watch:
Below you'll find a brief description of funds that we're now considering as possible new additions to our Low-Risk Funds Portfolio. We're following each of these funds closely and may add a few of them to this portfolio when their risk/reward profiles meet our stringent criteria. Here’s why each fund is worth following:

Oppenheimer Real Asset (QRAAX, $9.19) -- This fund buys bonds that are linked to the Goldman Sachs Commodity Index. It also holds futures contracts on oil, wheat, metals, hogs and other commodities. As one of a select group of funds that provides direct exposure to commodities, QRAAX is highly leveraged to commodity prices. With as much as 70% of its assets on energy-related contracts, the fund has been performing well recently. We will continue to watch QRAAX for an attractive entry point as oil prices taper off.

8.  "DIVIDEND OPTIMIZER" MODEL

Editor's Note: Each month we devote this section of the newsletter to an analysis of our proprietary dividend model. In doing so, we not only present you with the most recent rankings as of the beginning of the month, but we also summarize our performance and highlight particular firms that are moving up or down in our rankings.

In today's inaugural issue, Carla will devote this section to an introduction of the model, as well as a brief analysis of the spectacular results it achieved in its very first month (we ran the model for the first time on April 30th, 2004).

What is our proprietary "Dividend Optimizer" model?
Our proprietary model was built in two stages. First, we used a high-powered screening tool to narrow the vast investing universe of about 10,000 stocks down to just 100 companies with superior income characteristics and earnings potential. In doing so, we looked for firms with above-average dividend yields (higher than the average S&P 500 component), a record of strong dividend growth, superior earnings growth, etc.

This initial screen, which we will run just once a year, left us with a list of 100 possible income investments. To help you identify the best of the bunch, we then decided to rank these 100 stocks throughout the year. To do this, we developed a unique scoring system that assigns points to each company based on certain key income-oriented criteria. Although the specific details of this scoring system are proprietary, here are a few of the general items that the model looks for:

-- The higher a stock's dividend yield, the greater the number of points it receives.

-- The higher a stock's five-year dividend growth rate, the greater its point total.

In addition, our "Dividend Optimizer" formula looks at each firm's dividend yield in relation to its five-year average. Over time, every company's yield will tend to fluctuate both above and below its five-year average.

One of the goals of our model is to capture stocks when they are delivering higher-than-average dividend yields (such stocks are usually undervalued), and to avoid stocks that are delivering below-average yields (these stocks tend to be overvalued). With that in mind, the model adds points when a stock's yield is above its five-year average, but subtracts points from companies that are delivering below-average yields (relative to their own unique historical averages).

Based primarily on these criteria, our "Dividend Optimizer" model assigns a unique ranking to each of the 100 income stocks that we pre-selected in our initial screen. To assist you in sifting through the data, we then sort this list based on each company's rank. The higher the point total, the better, so we've sorted the list from the highest to the lowest-ranked stock.

In each future issue of High-Yield Investing we'll bring you a complete list of all 100 companies sorted by their most current rank. As prices and yields fluctuate throughout the year, stocks will move up and down in our rankings. By bringing you a revised ranking summary each month, we'll ensure that we provide you with the most timely investment ideas possible.

How Can You Take Advantage Of This Information?
Here are some items to look for when using the portfolio:

-- Focus on the top 25 companies (highlighted in yellow). If a stock appears among the top 25 companies month after month, then that suggests it delivers a rich dividend yield, strong dividend growth, and could also be undervalued relative to its historical norms. As such, it should tend to outperform its peers in the long term. All other things being equal, readers may want to consider accumulating these issues.

-- Look for companies that are moving up or down in the rankings. Stocks that are moving up have either boosted their dividend payments or have become more attractively valued in the open market. Meanwhile, companies that are moving down in the rankings are becoming a bit more richly valued relative to their historical norms.

-- Focus on the bottom 25 companies (highlighted in gray). Based on our model, if a stock appears in the bottom 25 companies month after month, it probably doesn't offer a sizable dividend yield and strong growth. Alternatively, it may be somewhat overvalued relative to its historical norms. As such, it is more likely to under-perform its peers going forward. All other things being equal, readers might want to consider reducing their exposure to some of these names.

How Can We Be Sure The Model Works?
Since we based both our initial screen and our proprietary scoring system on time-tested fundamental principles, we're confident that the top picks that appear month after month in our proprietary dividend model will outperform the broader market in the long haul.

However, to prove that the model does indeed work, each month we will track the average performance of the top 25 picks identified in the portfolio. We will then compare that performance against the S&P 500, as well as the Dow Jones Select Dividend Index. In the same way, to prove the model’s ability to identify income stocks that you might want to reduce your exposure to, we will also track the average performance of the bottom 25 picks and will compare that to both indices. As long as the top 25 picks consistently outperform the bottom 25 by a statistically significant margin, we will consider the model effective.

What Can You Expect To See In Future Issues?
Each month we'll present you with updated performance data, as well as NEW lists of the top and bottom 25 companies identified by our dividend model. Remember: These rankings change on a daily basis along with stock prices. Therefore, as prices and yields shift in the coming months, the top 25 companies identified by the model will change as stocks move up and down in our rankings.

Reminder
Again, it's important to emphasize the fact that this is a strictly quantitative model. Both the initial screen and our unique scoring system are based entirely on raw, objective data. We do not take any other fundamental factors into consideration and we do not make any subjective judgments at any time. This is important because if the model succeeds in identifying superior income investments, then we can continue to re-use this exact same ranking formula month after month.

Although we're encouraged by our model's early results and are confident that it will continue to deliver superior returns in the future, keep in mind that all investment decisions should be made based on a number of different considerations. The model is simply a useful tool that you can use to identify high-quality income stocks that may have become undervalued or overvalued. Like any tool, however, it should not be used in isolation. In addition to this quantitative model, readers should evaluate the fundamental characteristics of every potential investment opportunity. They should also evaluate how well a given stock meets their risk profile. That’s why we include in-depth profiles of each investment idea we present to readers in this newsletter, in addition to our proprietary model. In the final analysis, readers must make their own decisions regarding which investments best meet their needs.

Initial Results
Below you will find our most recent proprietary dividend model rankings for all 100 stocks: