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Sell your Bonds and Gold and Buy Dividend Growth Stocks Before it's Too Late

Introduction

Early in their careers investment professionals are taught the importance and benefit of properly diversifying their client's portfolios. Modern Portfolio Theory (MPT), which was developed and promoted by academia, has taken diversification to the extreme. According to Modern Portfolio Theory, asset allocation is the primary determinant of future returns and in the reduction of overall portfolio risk. Asset allocation is in effect a term suggesting that portfolios need always be diversified across numerous asset classes. In order to accomplish the proper balance, Modern Portfolio Theorists rely on sophisticated mathematical formulas.

Unfortunately, for these formulas to work the modern portfolio theorists had to conjure up the theory of efficient markets based on the premise that investors are rational and markets are efficient. This notion once led Warren Buffett to quip: "if the markets were efficient, I would be a bum on the street with a tin cup." In truth, there is growing evidence that investors are not always rational and markets (the stock market) are neither efficient nor always rational. We believe that now represents one of those times where several markets are not only behaving very irrationally, but also very inefficiently.

Consequently, although we generally believe in the soundness of the principle of diversification, we also believe that extraordinary times require extraordinary measures. Any historian of markets or economies would acknowledge and agree that many of our financial markets are currently far from behaving ordinarily. With this article we intend to point out several markets that are behaving both inefficiently and completely out-of-sync from sound and prudent economic principles. Therefore, we will argue that certain sacred cows that would and should apply during normal circumstances need to be questioned and challenged in these very uncertain times.

Speaking for myself personally, I have managed assets for individuals for more than 40 years. During the vast majority of this tenure, I have adhered to the principles of a diversified portfolio comprised of a mix of equity and debt (stocks and bonds). Although I have not personally utilized commodities or hard assets, I did not strenuously object to their inclusion into a client's portfolio at an appropriate level. However, for the first time in more than four decades I have altered my traditional position. What follows next articulates the reasons why, and provides supporting evidence behind my current position. It's up to the reader to evaluate the information and decide for themselves whether they agree or disagree.


The Problem with Bonds Today

One of the most important changes in my attitude regarding a client's proper portfolio mix is my current eschewing of bonds and other debt instruments. If the client currently holds a properly constructed portfolio of bonds with laddered maturities, I would suggest holding maturities that make sense, and selling those that don't. In order to make sense, the profit received minus taxes would have to allow the owner to harvest their gains and reinvest without sacrificing current yield. However, consideration needs to also be given to the reality that any current price appreciation on their bonds will disappear in the future as the bonds move closer to majority.

Next, let me present why I feel as strongly as I do. The following Bloomberg's Chart of the Day published last November compares the 10-year treasury yield versus the S&P 500 dividend yield since the 1950s. This chart clearly provides evidence of why bonds have historically made sense for investors to own. In addition to safety, the big reason was a yield significantly greater than the one offered from equities. Consequently, investors needing income looked to bonds simply because equities did not offer enough income to meet their needs. Clearly, this graph now shows how that differential, or gap, has not only been closed, but is actually close to reversing.

Bloomberg's Chart of the Day - S&P 500 Payout Exceeds 10-Year Treasury Yield
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This next Bloomberg chart published on August 12, 2011 looks at 10-year treasuries versus the S&P 500 since 2007. Note from the commentary that the closing of this yield gap is attributed to plunging share prices which could simultaneously imply low stock valuation generating the higher yield. But most importantly, note that the author, David Wilson, suggests that these days U.S. investors looking for income might be better off with stocks than bonds. Although we generally agree with Mr. Wilson's opinion, we would recommend looking more specifically at individual stocks rather than the S&P 500 index. Later in this article we will elaborate more on this point.

S&P 500 Payout Beats Bond Yield
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The Problem with Gold Today

The use of gold as a medium of monetary exchange spans the entire history of mankind and is even prominently mentioned in the Bible. Consequently, there is no question that mankind has always valued gold. However, the real question is what is the proper intrinsic value of this coveted element? When attempting to answer this question, consideration needs to be given to the fact that gold, unlike a stock or bond, does not pay income. Therefore, gold's future value and return potential must come from appreciation in its price. Of course, this implies the need to buy low in order to sell high.

The following graph, once again courtesy of Bloomberg, published on August 4, 2011 shows that gold is currently the most expensive it has ever been relative to global equities. If the reader focuses on the timeframe 2008 through 2010, the potential volatility of holding gold today can be vividly seen. This graph certainly makes a case for taking some profits off the table if not coming out of gold altogether. This is not to imply that gold cannot go higher than it already is, because there is no way to precisely quantify how irrational a market can be. But even the most fervent gold bug must acknowledge that this precious metal is not cheap today.

Stocks Cheap to Gold
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This next chart going back to 1975, courtesy of Kitco, illustrates that gold has historically been priced at around $200-$400 per ounce during strong economic times. However, after the recession of 2001 the price of gold has been on an undeniable and powerful advance. Also, notice the similar price action of gold from 1975 to 1980 where gold peaked at around $850 per ounce.

Gold - London PM Fix
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This next chart shows how precipitously gold can fall after it reaches aberrant and lofty levels. This is a risk that owners of gold should at least acknowledge and be aware of. From 1982 to year-end 1984, the price of gold fell from approximately $850 an ounce to $300 an ounce. That's more than a 65% loss, and notwithstanding the occasional rally, gold more or less traded in a narrow range until the recession of 2001. Gold is clearly a great hedge during weak economic times, and a very poor investment that offers little growth and no income during strong economic times.

Gold - London PM Fix
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A Rare Opportunity to Invest in Dividend Growth Stocks

Thus far this article has focused on comparing 10-year Treasury bond yields to the yield on the S&P 500 index. But, since the S&P 500 represents the average, and we endeavor to be better than average, we have screened the universe in order to compile a list of high quality companies offering a dividend yield greater than 3%. Moreover, each election had to have increased their dividends every year for at least 15 years and possess high financial strength ratings. Consequently, each of these selections offers an entry yield greater than the 10-year Treasury bond and most of them offer an entry yield this is remarkably greater than even the 30-year Treasury bond. As the first graph in this section, courtesy of Bloomberg, suggests, quality stocks with reliable earnings are very cheap today.

Stocks with reliable earnings
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The following portfolio review courtesy of F.A.S.T. Graphs™ lists the 30 companies with dividend yields of 3% or greater and the quality characteristics we screened for and mentioned above. These selections are listed in order of their potential five-year estimated annual total return based on consensus analyst estimates for earnings growth over the next five years. A combination of below-average current valuation coupled with a return to fair value provides the basis behind these return objectives. We have shaded the column showing each company's current PE Ratio in green, and its historical PE Ratio is shaded yellow, this focuses on the normal valuation discrepancy.

Therefore, not only do these high-quality dividend growth stocks offer the potential for a current yield equal to or greater than even the 30-year Treasury bond, capital appreciation potential is extraordinary as well. As a result, this list of dividend growth stocks could satisfy both the dividend growth investor and those concerned with total return. We feel that that is just as unusual to find these types of quality companies at such low valuations, as it is to see bond yields as low as they are and gold prices as high as they are. These are truly extraordinary times.

Corp List

This above list of companies is offered as a potentially fertile starting pointworthy of a more comprehensive due diligence process. Although there is no shortcutfor doing your homework before investing in common stocks, it helps to efficientlyonly invest your time and effort where the potential to bear fruit is most evident.We believe the above list represents several attractive candidates worthy ofthe effort. Aflac Inc. (AFL) A Comprehensive ExampleOne of the great advantagesof using a research tool like F.A.S.T. Graphs™ thatcorrelates fundamental value with stock price is the opportunity to clearly seewhen Mr. Market is behaving inefficiently. The following earnings and price correlatedgraph shows how the market has traditionally valued Aflac's stock with a highcorrelation to its intrinsic value based on earnings (the orange line). However,today we see that earnings have continued to advance while stock price has fallento an inexplicably low value. In other words, we believe it's obvious that thefundamentals underpinning this high-quality underwriter of supplemental cancerinsurance warrant a much higher valuation (see flag on graph representing fairPEG Ratio value) from Mr. Market.

Earnings and Price Chart

The associated performance results with the above graph shows that Aflac's strong operating performance was able to generate significantly above-average shareholder returns including an increasing dividend income stream in spite of today's current low valuation. Imagine what these returns are going to look like when the market eventually and we believe inevitably, returns the shares to their fair value. We believe a minimum PE ratio of at least 15 is warranted which implies an almost tripling over today's price.

AFLAC Inc - 15 Year Performance Results

We have included an additional performance report on Aflac (AFL) going back to 1992, which is as far back as our F.A.S.T. Graphs™ is capable of going. We believe showing these additional five years illustrate the long-term potential of investing in a quality dividend growth stock like Aflac Inc. (AFL).

AFLAC Inc - 20 Year Performance Results

Although Aflac does business in Japan and all 50 United States, their Japanese operations accounted for 75% of revenues and an approximately equal amount of profits in 2010. The following analysis was provided by a commenter on another article I wrote that featured Aflac Inc. among seven other companies. With his permission, I offer it as an example of the type of information and perspective that a comprehensive research effort is capable of producing:

"The one that can last forever is Aflac.

Aflac is a monopolistic compounding-machine in Japan. Yet, its shares have plummeted nearly 40% recently over its portfolio concerns, which is 30% in financials and 8% in perpetuals. Euro-periphery holdings are a source of significant downward pressure at the moment. Still, if all the euro-zone exposure were 'salad oil' and disappeared, Aflac's RBC ratio, presently over 400%, would nevertheless be adequate and it would still earn its stellar returns year after year into the foreseeable future. According to the most recent quarterly report, 2011 operating earnings are estimated at $6.20 or so for a stock that trades at $36, and that's with an 80yen/dollar exchange rate...and the yen has since strengthened to 77/dollar.

Aflac has some unbelievable "moat" statistics. It:

  • Consistently makes an Underwriting combined ratio of over 15%, and has for over a decade, year in, year out. Currently it is about 18%. The company could put the float in its mattress and still do well...
  • Is by far the low-cost operator in Japan, being free from its competitors' costs of in-house and inefficient Japanese sales forces.
  • Writes cancer and health insurance in a country full of the healthiest, longest lived people
  • Pays claims in a country where fraud is lower than any other major insurance market.
  • Faces competitors who are systemically inefficient, questionably capitalized and still badly damaged from the bubble burst and Asian financial crisis of the late 90's
  • Has a monopoly on sales through the best sales channel, the Japan Post
  • Has the number one brand in the most brand conscious society on earth.
  • Has a persistency rate of nearly 95% in Japan
  • Has grown its float every year for decades, at over 10% avg. per year.
  • Has a 75% (that's right) market share of in-force cancer insurance, its core business.
  • Is the number one insurer in Japan by number of policies issued.
  • Has bought back shares nearly every year for a decade.
  • Has a portfolio exclusively filled with bonds...no real estate or equities.
  • Earns money in Yen, a currency whose value is forced up by perpetual trade surpluses, positive capital inflows, and a net-saver electorate.
  • Reports its earnings in dollars, whose value is likely to fall, as it is a net debtor nation with intractable trade, current account and government deficits.
  • Can use windfall profits from Japan to underprice its competitors in the US.
  • Has a grandfathered and cozy relationship with regulators in Japan, who are not likely to change much, considering the annual collapse of the Japanese cabinet and 'twisted' Diet.
  • Prices its policies in an old-school cartel-type system, long gone in the States
  • Has only one set of insurance regulators to worry about in Japan, instead of 50 in the U.S.
  • Stands to gain policy holders as Japan's indebted government trims coverage under its National Health Insurance.
  • Has no inflation risk in its policies, as they are defined payout policies and shift all inflation risk to the policy holders. (I love this one, personally)
  • Has evolved one of the most highly recognized trademarks in Japan, the maneki-neko duck.
  • Holds over 30% of its portfolio in Japan Gov't Bonds, which it must in order to match its liabilities, the yield on which is likely to rise in the future.
  • Operates in a short-tail environment with little re-insurance makes it far more likely that the company is pricing its policies right and reserving adequately.
  • Has operating costs in a deflationary environment, where deflation lowers its effective costs of doing business, while the same deflation depletes the reserve ratios of its competitors, who have Japanese equities and (ugh! real estate!) in their investment portfolios.

I could go on (and on) but this is a wonderful compounding machine which has a monopolistic lock on possibly the best insurance market in the world. And anyone can buy it right now for a 5.3 multiple on Value line's next-year estimated EPS. That works out to just under 20% earnings yield. And mind you, that yield has historically grown at 14% measured over the past decade.

So here's a Buffett stock. It yields 20% now and stands to grow at 14% annually, and maintains a best-in-breed near-monopoly. That is what GEICO was back in the day. It's why I'm long the company too."

How's that for a description of a great company on sale? Confidence comes from doing your homework, and knowledge is truly power.

Thanks to Mcwillia for allowing me to share the above.


Conclusions

Clearly this article flies in the face of conventional thinking regarding portfolio construction and the principles of diversification. However, as we've tried to illustrate, today's economic environment and the associated investment opportunities are far from conventional. Therefore, as previously stated, extraordinary times call for extraordinary actions. In essence, we feel this article does deal appropriately with the real realities of various market risks that investors face today. Equities as an asset class are currently shrouded in pessimism. This has caused valuations to fall, even for those companies that have maintained strong business models and operating results in spite of the economic turbulence.

Almost a year ago to the day, Professor Jeremy Siegel authored an article titled "Bond Risks and How to Avoid Them" where he stated the following:

"The potential losses on 30-year Treasury bonds, which are often used to fund IRAs and 401(k) accounts, are much worse. If the 30-year treasury yield, which ended August at 3.52%, returns to its April high, bondholders will suffer a loss of 17%. If yields reach the average level it has been over the past 30 years of 7.3%, the bondholder will experience a price a decline of 50%, equal in magnitude to the worst bear markets in stocks in the past 50 years. For those investing in bond funds, these losses will never be recovered unless interest rates return to current levels."

Obviously Professor Siegel was early with his admonition. This highlights the reality that forecasting short-term movements of markets is fraught with uncertainty. However, we believe that the underlying principles and rationale behind Professor Siegel's thesis are sound in the longer run. Interest rates have continued to fall since the above article was written, however, we would contend that there is not much room left for them to fall. Gold has shown some recent weakness, but continues to sit at extremely lofty levels.

Finally, we may have not hit the very bottom for stock prices yet, as investor pessimism is a force to be reckoned with. On the other hand, today's valuations on high-quality dividend growth stocks make more sense than they have in many decades. So even if this is not the perfect time to invest in them, we fervently believe that it's as good a time as any rational investor could ask for. We do believe in diversification, but not at the expense of good judgment. We also believe that we will be willing investors in bonds again, but not today. We hope at the very least this article has provided points for the rational thinker to ponder.

 


Disclosure: Long: CVX, AFL, AVP, ITW, ABT, NVS, NEE, SYY, PEP, GPC, JNJ, KMB, PG, CLX, ADP.

 

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