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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% 3 1 2 W a l n u t S t r e e t , S u i t e 3 1 2 0 | C i n c i n n a t i , O H 4 5 2 0 2 | 1 - 8 0 0 - 5 4 8 - 1 6 2 5 | F: 5 1 3 . 4 2 1 . 5 9 4 8 | www.riverpointcm.com Page 2 RiverPoint Capital Management 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. 3 1 2 W a l n u t S t r e e t , S u i t e 3 1 2 0 | C i n c i n n a t i , O H 4 5 2 0 2 | 1 - 8 0 0 - 5 4 8 - 1 6 2 5 | F: 5 1 3 . 4 2 1 . 5 9 4 8 | www.riverpointcm.com RiverPoint Capital Management Page 3 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 3 1 2 W a l n u t S t r e e t , S u i t e 3 1 2 0 | C i n c i n n a t i , O H 4 5 2 0 2 | 1 - 8 0 0 - 5 4 8 - 1 6 2 5 | F: 5 1 3 . 4 2 1 . 5 9 4 8 | www.riverpointcm.com Page 4 RiverPoint Capital Management 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. 3 1 2 W a l n u t S t r e e t , S u i t e 3 1 2 0 | C i n c i n n a t i , O H 4 5 2 0 2 | 1 - 8 0 0 - 5 4 8 - 1 6 2 5 | F: 5 1 3 . 4 2 1 . 5 9 4 8 | www.riverpointcm.com