Wednesday, August 4, 2010

Stocks versus bonds as of August 4, 2010

Recently investors have fled stocks and embraced bonds en mass. Let's take a critical look at the comparison of the two.

US ten year bonds as I write this pay interest of 3.11%. $10,000 invested in these bonds over 10 years will yield a total of $3110 over the life of the bonds disregarding reinvestment of interest. After taxes maybe about $2650 in the 15% bracket. After taxes and inflation maybe, just maybe $1000 optimistically.

Blue chips stocks consisting of KO, MCD, ABT, PG, and CLX invested in equal amounts currently yield at today's price 3.36%. Now these stocks over the past 25 years have each raised their dividends every year. KO ten years ago paid a 0.68 dividend. Today it pays $1.76 or 2.5 times as much. ABT ten years ago paid 0.74 today it pays 1.76 or 2.4 times as much. Ten years ago PG paid 0.64. Today it pays 1.93 or 3 times as much. Ten years ago MCD paid 0.22. Today it pays 2.20 or 10 times as much. Ten years ago CLX paid 0.61. Today it pays 2.20 or 3.6 times as much.

But wait you say. The average price of a stock has lost value over the previous 10 years whereas you know that if you buy a treasury bond in ten years you will get your money back.

Not so fast. It is true that 10 years ago CLX was selling at 26 times earnings on average and today it is selling for only 15 times earnings. In that sense it has lost value. But during that ten years earnings have grown from 1.64 a share to currently about 4.24 a share. Ten years ago the average price per share was 42.50 a share. Today it is 64.50 a share.

10 years ago PG was selling at 35 times earnings on average and today it is selling for only 16 times earnings. During that 10 years earnings have grown from 1.24 a share to 3.67 a share. Ten years ago the average price per share was 43. Today it is 60 a share.

The same case holds true for the other three stocks also.

So if you hold $10,000 worth of 10 year US treasuries, your after tax return will be about $2650 in ten year. On the other hand if you hold these 5 blue chip stocks your expected return over a 10 period based on history will be considerably greater than $2650. It is perhaps unlikely that the dividends will rise as much during the next 10 years as they have during the past 10 years, but let's assume they will rise 8% annually. In that case in 10 years they will be 2.16 times as much as they are now. The total dividends expected during that period will be $4867. If the current tax rate on dividends should continue which it might not, the after tax amount in the 15% bracket would be $4624 less state taxes. Dividends are currently taxed at only 5% in the 15% bracket. In addition to the increased dividends, there should also be based on history capital gains on this investment. If we use the last 10 years as our guide the capital gains will be in the order of 35% in ten years. Remember though that ten years ago these stocks were all selling at a PE ratio that was considerably higher than they are today. KO at 60, today at 16. MCD at 24, today at 16. ABT at 24, today at 12. CLX at 26, today at 15. PG at 35, today at 16. With 35% capital gains there will be an additional $3500 in return which will not be taxed at all so long as the stocks are not sold, giving a total expected potential return of $8124 versus $2650 for 10 year US bonds.

If history is any indication at all, and it might not be, then there is a very strong case that investing in blue chip dividend paying stocks will be a much more worthwhile experience over an extended period of time than investing in bonds.

I will point out that there is more risk in investing is stocks than in bonds but that risk can be mitigated by investing in at least five different stocks and investing in leaders in their industry positions as are these five companies. It is worth pointing out though that at one time GM was an industry leader and also considered a blue chip stock. Last year it went bankrupt. The same could once be said about US Steel. It did not go bankrupt but it is just a shadow of its former self. There are countless other such tales. AIG, C, BAC, GE. The latter four are financial companies. Perhaps that should indicate something to avoid.

One final thought. The average PE of these stocks is among the lowest it has been in the past 10 years. ABT is currently at 12. During the past 10 years it has ranged from 11 to 58. It is currently very near the 10 year low. The same can be said about the other four.