Download low rates, plus inflation, makes dividend stocks more attractive

MARCH 2, 2012
LOW RATES, PLUS INFLATION, MAKES
DIVIDEND STOCKS MORE ATTRACTIVE
Market watchers like round numbers, and this week the Dow Jones
Industrial Average has been flirting with (and briefly topped) the 13,000
mark. It’s the first time since May, 2008 that we’ve seen this level and, for
all of us at RiverPoint, it’s a welcome sight. Let’s hope the market keeps
heading up at its current pace – if it can, we’ll be mentioning “Dow
14,000” in a few short months!
Warren Buffett thinks of
investment risk in terms of
potentially diminished
purchasing power.
The RiverPoint Team
Valerie L. Newell, CPA
Leon H. Loewenstine, CPA
Victor R. Lassandro III
Pamela F. Schmitt, CFA
Ryan L. Brown
Anthony Roberts III, CFA
Kirk M. Koppenhoefer, CFA
In his recent letter to Berkshire Hathaway shareholders, Warren Buffett
described investment risk as the “reasoned probability of that investment
causing its owner a loss of purchasing power over his contemplated
holding period.” In other words, the impact of inflation on investment
returns is a very important consideration; this is particularly critical for
conservative investors, as low interest rates offer little chance to keep up
with inflation. By extension, it is hard to imagine bonds outperforming
stocks over the next several years, especially with bonds yielding less than
their equity counterparts.
At RiverPoint, we choose between three investment classes in order to
achieve this goal of increasing future purchasing power – fixed income
securities, hard assets (aka non-productive assets), and equities (aka
productive assets).
Let’s examine fixed income securities first. A fixed income security
provides a “fixed” rate or level of income for a set period of time. The
income payments are set beforehand, and don’t change over time; at the
end of a fixed time period, you receive your money back. Fixed income
investments tend to carry a relatively low level of risk and include US
Treasuries, corporate bonds, money market funds and similar securities.
Although an allocation to fixed income can provide a certain amount of
stability to an investment portfolio, investors may want to reconsider the
size of their fixed income investments when yields are at or below the rate
of inflation. Right now, high-quality corporate bonds yield between 2%
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and 2 ½%. Inflation, measured by the annual change in the Consumer
Price Index, has been running at similar levels and is expected to move
higher over time.
What impact does inflation have on purchasing power? The following
table illustrates how dangerous inflation can be on fixed incomes:
If you invest $10,000 in a 2.5% bond, you will earn $250 in interest each
year and get your $10,000 back at the end of five years – no more, no less.
Inflation, however, effectively reduces what you can buy with those fixed
dollars. Even more, inflation can rise every year, compounding the decline
in purchasing power. As evidenced in the table above, 2% inflation
significantly eats away at future purchasing power, leaving the $10,250
you’d receive in 2017 worth only $9,265 in today’s dollars.
With hard assets, you are
guaranteed that your
investment will NOT grow
over time.
Hard assets are another type of investment option to consider. With these
– namely, physical commodities – you are guaranteed that what you buy is
what you will have in five, ten, fifteen, twenty years. Want to buy an
ounce of gold now? If so, there’s a 100% chance that you will wake up in
2017, 2022, 2032 - whenever – with exactly 1 ounce of gold. Returns on
these non-productive assets are predicated on someone else wanting to pay
more for them at some point in the future. Gold, much like bomb shelters
and astronaut food, is somewhat unique in that it generally finds new
buyers as fear of calamity spreads. At RiverPoint, our goal is to invest our
clients’ money in securities that have a reasonably high likelihood of
producing attractive returns over the next couple of years; we don’t
purchase assets with the hope that someone else will freak out more in the
future.
Finally, productive assets are those that produce, profit, and pay off (either
in the form of dividends or capital appreciation). Common stocks fit the
bill here, as each share represents an ownership stake in a productive,
ongoing enterprise. An investment in common stocks pays off in two
ways: through dividends paid to the owners in cash, or as capital
appreciation brought on by increasing profits.
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Now, the really great thing about investing in common stocks is that the
rewards can continue to grow over time. Fixed income securities and
(especially) unproductive assets do not provide this wonderful perk to
their owners. Also, many equities provide a high degree of price stability
over longer periods of time. At RiverPoint, because of the current low level
of interest rates, we are increasing our clients’ equity allocations to include
high-quality, dividend paying stocks where price volatility is generally less
than the broader equity market and dividend yields are attractive relative
to bonds.
General Mills is just one
example of a stock that
offers growing dividends
AND a high degree of price
stability over time.
As an example, we compared the stock of General Mills (the venerable food
and cereal maker; ticker: GIS) with what you could reasonably expect from
a high-quality corporate bond maturing in five years. In our analysis, we
looked at General Mills stock returns over rolling five-year periods going
back to 1990. We found that General Mills averaged a 6.1% annual return
over that period, and NEVER lost money in any of those five-year periods
(worst performance: +0.3% for the 5 years ending July, 1996). In addition to
consistently positive returns, General Mills also has a history of increasing
its dividend payments to shareholders. Over the past 5 years, the company
has raised its dividend by 11% per year. Using these facts as our baseline
assumptions, we decided to compare what an investor could reasonably
expect from a $30,000 investment in General Mills stock to what one could
expect from an equivalent investment in a corporate bond yielding 2%:
If the above chart shows anything, it’s the power of growth over time.
General Mills’ growing dividends provide 8% higher returns over the fiveyear holding period. Including just average 5-year returns for General
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Mills (6.1% per year), your $30,000 in GIS stock would be worth 39% more
than the bond investment. This type of growth – either in dividends or
stock price – can have a material impact on investment returns and, more
importantly, can provide significant protection against inflation. Other
stocks with similar profiles include McCormick, Procter & Gamble, Johnson
& Johnson, Southern Company and PepsiCo.
Europe, the Middle East, and
elections in the US present
enough uncertainty to
maintain some exposure to
fixed income securities.
It is with this in mind that we are beginning to invest a portion of our client
accounts in equities which we consider “bond surrogates” (like GIS). These
stocks are high-quality companies with consistent (if unspectacular)
histories of earnings growth that can provide dividend yields greater than
the broader market. We will continue to maintain an allocation to highquality bonds in order to provide current income and principal stability,
which we view as prudent with uncertainties regarding Europe, Iran, and
the US Presidential election lurking in the background.
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