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Saturday, October 16, 2010

Stocks vs. Bonds: Where to Stash Your Cash? (Revisited)... Hint: "It's All About What You Pay and What You Get!"

In November of last year, we shared "Don't Forget About Dividends" and relayed "the power of payouts" compounding over the long-term. More recently, in early August, we shared this post: Where to Stash Your Cash? Listen to Hersh Cohen: Buy Equities that "Just Make Sense!". Here, we wanted to address common questions such as:
  • "Bond yields are so low, there's nowhere to generate any sort of decent return on our savings." Or, another one: "How are America's retirees going to live off of 1-2% interest income?" Or, "My CDs are expiring, where shall I roll them over?"

Our conclusion: the answer is surprisingly simple: invest in high quality companies with solid balance sheets that (1) sell or provide products or services that people need to buy (think cleaning supplies, food, beverages, telco services, etc.) and (2) offer reasonable, growing streams of dividends. To highlight this strategy, we shared Hersh Cohen's "Where to find income" from WealthTrack (video from 7/23/10).

We followed this discussion with another post (8/28/10) on stocks versus bonds, and again in Who's Driving the Bus? (9/14). We've been meaning to round out these posts with some additional commentary. Here we go.

First, we ALL continue to see headlines such as the following:
  • Gold sets record as Fed easing hopes hit dollar (Reuters) - Gold surged nearly 2 percent to a record high near $1,375 an ounce on Wednesday, boosted by worries over currency depreciation after the Federal Reserve signaled it will resume buying government debt to stimulate the economy. It was the biggest percentage gain since September 14 for gold, which has rallied 25 percent so far this year. Investors have sought safe havens with the Fed and other central banks professing readiness to inject more money into the financial system, a procedure known as quantitative easing.
  • Stocks Dip, Treasury Yields Drop After Jobs Data- AP (10/6/10) - Stocks dipped Wednesday after a disappointing report on the jobs market renewed concern about the economy. Treasury yields sank to new lows as investors sought safety and anticipated more stimulus measures from the Federal Reserve. [note: yields inversely related to prices - lower yields = higher prices]
Not to mention regular talk of the "new normal" and weak personal incomes:
  • Gross Says Druckenmiller's Exit Marks `Old Normal' End in Capital Markets - Bill Gross, who runs the world’s biggest mutual fund at Pacific Investment Management Co., said the planned exodus of hedge-fund icon Stanley Druckenmiller helps mark the end of the “old normal” for investing.... “The new normal has a new set of rules. Leverage and deregulation are fading from the horizon and their polar opposites are in the ascendant,” Gross added.
  • No wonder New Yorkers are feeling the pinch - Personal incomes fell in the Empire State last year for the first time in 70 years, a new report revealed Wednesday.They tumbled "almost twice" as much in New York as in the rest of country - a 3.1% dent to local wallets totalling a staggering $908 billion in lost income, according to state Controller Thomas DiNapoli.
AS ALWAYS, the headlines can easily sway and/or cloud the minds of even the best investors. We're all human. That said, per our August post, we agree with Mr. James Grant that there isn't a "new normal" -- recall that he says, "there isn't any 'new'! It's always cycle after cycle, you go from extreme to extreme." Further, he sensibly reminds us of advice from Graham and Dodd - "can't know future, therefore seek margin of safety.... in investments in present.... can't know what will happen in 2010 let alone 2017, but can observe two things: opportunities in front of us as now priced; and, how the world is positioning itself for an expected outcome."

BUT, let's consider the rationale for putting money in bonds via an insightful perspective on the economic outlook and the confluence of trends impacting jobs, interest rates, inflation, deficits, gold values, and related subjects.

His key messages:
  • The FED's efforts to re-inflate the economy are merely countering post bubble credit contraction in an economy still filled with excess capacity.
  • As a result, we MIGHT be in for a prolonged period of price stability (potential good news).
  • However, deflationary pressures remain widespread and, thus, focus on bonds (*possibly over-weighting high quality corporate bonds versus alternative bond types).
  • As for maturities: "The higher the quality the longer the duration, the lower the quality, the shorter the duration."
  • While each client may have different needs, he recommends [only] 20% equity exposure into companies with solid balance sheets and products/services that people need to consume (e.g. consumer staples).
  • He recommends gold, silver mining companies.
  • "We're in a secular bear market."
He makes a number of interesting, well-articulated points, particularly around all of the well-known challenges that plague the American psyche and are regularly discussed in mainstream media. In fact, we've also covered popular risk factors in certain prior posts. We don't have answers for all of the problems. Then again, there's always plenty to worry about. If it's not one thing, it's another. The real question with any investment -- bonds or equities -- always comes down to this, courtesy of Bruce Berkowitz (variation on advice from Warren Buffett and Ben Graham): "it's all about what you pay and what you get."

In this respect, we recommend reading an 8/18/10 WSJ opinion by Jeremy Siegel and Jeremy Schwartz:
  • The Great American Bond Bubble - If 10-year interest rates, which are now 2.8%, rise to 4% as they did last spring, bondholders will suffer a capital loss more than three times the current yield.
Before we share a few points directly from the article, please note the background of the authors (cynics/critics might point to a bias conflict): "Mr. Siegel is a professor of finance at the University of Pennsylvania's Wharton School and a senior adviser to WisdomTree Inc. Mr.Schwartz is the director of research at WisdomTree Inc." Mr. Siegel is also author of Stocks for the Long Run and The Future for Investors: Why the Tried and True Triumph Over the Bold and New. We recommend both books.

In our view, the WSJ article makes a number of common sense points, some of which we relay here:
  • Ten years ago we experienced the biggest bubble in U.S. stock market history—the Internet and technology mania that saw high-flying tech stocks selling at an excess of 100 times earnings. The aftermath was predictable: Most of these highfliers declined 80% or more, and the Nasdaq today sells at less than half the peak it reached a decade ago.
  • A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites. The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows.
  • We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.
  • The rush into bonds has been so strong that last week the yield on 10-year Treasury Inflation-Protected Securities (TIPS) fell below 1%, where it remains today. This means that this bond, like its tech counterparts a decade ago, is currently selling at more than 100 times its projected payout. Shorter-term Treasury bonds are yielding even less. The interest rate on standard noninflation-adjusted Treasury bonds due in four years has fallen to 1%, or 100 times its payout. Inflation-adjusted bonds for the next four years have a negative real yield.
  • From our perspective, the safest bet for investors looking for income and inflation protection may not be bonds. Rather, stocks, particularly stocks paying high dividends, may offer investors a more attractive income and inflation protection than bonds over the coming decade.
  • Today, the 10 largest dividend payers in the U.S. are AT&T, Exxon Mobil, Chevron, Procter & Gamble, Johnson & Johnson, Verizon Communications, Phillip Morris International, Pfizer, General Electric and Merck. They sport an average dividend yield of 4%, approximately three percentage points above the current yield on 10-year TIPS and over one percentage point ahead of the yield on standard 10-year Treasury bonds. Their average price-earnings ratio, based on 2010 estimated earnings, is 11.7, versus 13 for the S&P 500 Index. Furthermore, their earnings this year (a year that hardly could be considered booming economically) are projected to cover their dividend by more than 2 to 1. Due to economic growth the dividends from stocks, in contrast with coupons from bonds, historically have increased more than the rate of inflation. The average dividend income from a portfolio of S&P 500 Index stocks grew at a rate of 5% per year since the index's inception in 1957, fully one percentage point ahead of inflation over the period. That growth rate includes the disastrous dividend reductions that occurred in 2009, the worst year for dividend cuts by far since the Great Depression.
IN OUR VIEW, Messrs. Siegel and Schwartz paint a fairly black and white picture: the ongoing mad rush into bonds is akin to investors blindly buying Internet stocks in the late 1990s at completely egregious valuations that we're bound to disappoint (i.e. lemmings following each other over the cliff). Meanwhile, today's shunned equities -- especially large, stable companies -- offer havens of safety with superior current yields AND a history of growing dividend income streams over time.

To bring home this point, let's look briefly at Johnson & Johnson (JNJ). The company's share price has been largely range bound over the past decade (unless shares were purchased in the mid-$40s in 2000-01 versus today's mid-$60s) -- from Google Finance (GOOG):

HOWEVER, Johnson & Johnson's annual dividend payout has increased dramatically (2010 includes only three quarters to-date):

While the company faces current challenges around product quality (please see this well written Fortune article: Why J&J's headache won't go away), we're fairly confident that J&J's dividend profile will remain strong and, likely, increasing over the coming decade.

We don't have a position in Johnson & Johnson, but do hold smaller companies that are dividend payers such as Compañía Cervecerías Unidas S.A. (CCU), Lance Inc. (LNCE), NTELOS Holdings (NTLS), PriceSmart (PSMT), and Weight Watchers (WTW). For some of these names, recent stock runs leave valuations somewhat less attractive than earlier this year. We also hold a large position in Seaspan (SSW), where we see potential for meaningful dividend increases over time. Likewise, our aircraft leasing company, FLY Leasing (FLY), offers a healthy payout and continues to trade at a discount to net tangible book value.

TO CONCLUDE: we hear Mr. Rosenberg's well-articulated rationale and are aware of the many problems facing our country, thanks primarily to the easy credit years and aging demographics that make earlier pension promises untenable. Nonetheless, we continue to see many values in equities and also note that (we believe) approximately 50% of S&P 500 earnings are now derived abroad, thereby providing an excellent growth engine for American equities. HONESTLY, while acknowledging that everyone faces different circumstances and needs, we're not sure why anyone would NOT have a large allocation to dividend paying stocks.

Why purchase bonds at 100 times projected payouts when high quality stocks can be purchased at low teens multiples with a 3, 4, 5% yield that will probably increase over time?

Happy investing,

Jeffrey Walkenhorst

Disclosure: long CCU, FLY, LNCE, NTLS, PSMT, SSW, WTW.
© 2010 Jeffrey Walkenhorst
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