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.

Getting an early start at investing

It may not seem obvious but the earlier one starts investing, the better the odds that one will accumulate the money one requires at a later time. The secret word here as Groucho Marx would have said is compounding. Given sufficient time compounding can turn a small amount of money into a significantly greater amount. The key word here is time. Consequently, a person that starts a saving program at say age 18 is going to accumulate a great deal more wealth than a person who starts a saving program at age 28.

This can best be shown by an example.

A person who is 28 might be expected to be able to save significantly more money than a person age 18, but by the time the person age 18 reaches age 28, that person should also be able to save an equivalent amount other things being equal.

Let's assume that the 18 year old can save only $50 a month and that the growth rate of those savings is 5% annually. Then by age 28 that person will have accumulated $7546. Without saving another red cent, in 40 years that amount will then be worth $53,123 from an initial investment of only $6000.

But how much will the 28 year old have to save each month for 10 years to arrive at the $53,123 at age 68? The answer is $81.44 a month or about 62% more than the 18 year old. But remember the 18 year old is not going to stop investing just because he reached age 28. He/she is going to continue saving and investing.

Dividends

I recently ran across a link to a spreadsheet of US stocks that have increased their dividends each year for at least the last 25 years. It is something that must be shared and here it is.

http://dripinvesting.org/Tools/Tools.asp

I was quite surprised to learn that the list includes 100 companies.

Aeropostale ARO

Aeropostale ticker ARO is a clothing chain that caters to the young set--13 to 17 years old. I normally am not a fan of clothing stores. They tend come in and go out of fashion very fast. But this particular chain has a couple of things going for it currently. First of all their clothing is not extremely high priced. That makes it very attractive in this tight environment. Secondly, the stock is selling at a very low PE ratio in comparison to other clothing chains.

Let's take a look at the company financials.

Revenue is $2.23 billion.
LT debt is zero
Equity per share is $4.62
Return on assets is 31.6%
Market cap is about $2.6 billion.


Historical data for the company is:

2006 eps $0.67 revenue $1.2 bil
2007 eps $0.88 revenue $1.4 bil
2008 eps $1.13 revenue $1.6 bil
2009 eps $1.48 revenue $1.9 bil
2010 eps $2.28 revenue $2.2 bil

The company operates 938 stores. Of these 44 are in Canada. It also operates an E-commerce site--www.aeropostale.com. The company has begun opening stores focusing on children in the age group 7 to 12 under the name P. S. It has 14 stores under this label in 5 states.

The company just announced earnings for the first quarter of 2011 fiscal year as I write this.

eps for the quarter was $0.48 vs $0.33 for the previous year. Revenue was $464 million vs $408 million.

The current pe ratio with the current stock price at $27.14 is 11.9 for 2010 calendar year earnings. The pe ratio based on projected 2011 earnings is about 10.0.

How does this stock compare to its market segment stocks?

ARO pe 11.9 debt zero revenue growth rate 17% eps growth rate 35%
URBN pe 20 debt zero revenue growth rate 15% eps growth rate 13%

Discovery Communications

This is an interesting company. Most would recognize the Discovery Channel which is part of the company. Other channels that the company offers include Animal Planet, the Science Channel, and several other interesting offerings. I find the company interesting because their TV fare is considerably different from most of the other TV channels. Not only does their programming strive to entertain but it also strives to educate and inform. All that is really lacking in their offerings is a news channel and a finance channel to sort of round out their offerings. Maybe sometime in the future.

Discovery Communications is a publicly traded company and that is why I am posting this blog. It has several classes of stock outstanding--DISCA, DISCB, and DISCK. I am not all that fond of companies with different classes of stock, but I may make an exception now and then.

The financials of the company are as follows for 2009.

Revenue $3.5 billion
Net income $560 million
equity $6.2 billion
LT Debt $3.5 billion

The class A shares are trading for about $38-39 a share as I write this. With EPS of for 2010 projected to be about $1.64 the PE is about 24. It is currently a little too high to be considered a buying opportunity currently but on a pull back to about $34 the stock would look reasonably attractive.

One of the interesting aspects of this company is that it serves markets in 180 countries in 35 different languages. It truly serve a world wide market. I have watched the Discovery Channel is England, Estonia, Ecuador, and Peru. This company has the potential of becoming the Nestles of educational entertainment.

April Trip to Peru

My birding buddy Moe and I spent a month in southern Peru looking for birds. Among the places we visited, my favorite was Parque Nacional de Junin. This is near the town of Junin and rather off the beaten path. Accommodations there are somewhat basic. No shower--too cold--but there was a toilet seat and 4 heavy wool blankets on the bed. Junin is at about 12,800 feet and the evenings are cold. The park ranger took us out on the lake to find the Junin Grebe, a flightless bird found only here. This is an excellent site for birding. Around the lake were hundreds of Puna Ibises, Puna Teals, Yellow-billed Pintails, and many other birds. We spent only one day here but should have spent at least two days. From Junin we traveled to Tingo Maria to visit Parque Nacional Tingo Maria and the Oilbird Cave there. At 6:00 pm each night the Oilbirds fly out of the cave by the hundreds in search of fruit trees for their nightly meal along with hundreds of bats. One of the spectacular sites here is the giant spider that lives in the cave and eats Cockroaches. See photo. The Oilbird Cave area is also an excellent place to see the Sunbittern which is tame here. See photo. Our next stop was Yarinacocha and oxbow lake on the Río Ucayali near the large city of Pucallpa. This is a great place to hire a boat for the day and tour Yarinacocha and the Ucayali looking for birds. The Large-billed Terns and Striated Herons are abundant here and many other birds besides. After the boat trip you will want to stop for dinner at the local open air fish restaurant where you select from the day's catch and have it grilled over charcoal and washed down with the best beer in Peru--San Juan. It is a local beer found only around Pucallpa. I could have stayed there for another week just to drink the beer.

From here we took a flight to Iquitos. There are only two ways to get to Iquitos, by airplane or by boat. No roads go to Iquitos. The boat trip is about 4 to 5 days and is only for the very adventurous. The city has almost a half million people and some of them live in houses built on a platform of floating logs tied together with vines. See photo. Iquitos is very near the beginning of the Amazon river. We met three Americans in the mid-twenties there that had purchased a 24 foot canoe and were planning on sailing it down the Amazon to the Atlantic Ocean about 2000 miles. I wish them luck in their adventure.

After Iquitos we flew back to Lima to begin our trip down the Gringo Trail to Cusco. The trail goes first to Paracas-Pisco where one can visit the fish markets and take a boat trip to Islas Ballestas. It was somewhat astounding to see the hundreds of gringos packed into the boats heading for the island. The island is the best place to see the Humbolt Penguin and the Inca Terns and several other local specialties besides, but I believe that Moe and I were the only two there interested in seeing the birds specifically. The rest of the gringos I doubt new one bird from the other. We all did see lots of birds though.

From Pisco it is a quick bus trip to Nazca where small planes are waiting to whisk you over the Nazca Lines. Last year a pilot had a heart attack and killed himself and a couple of tourists from Chile so now all planes have a pilot and co-pilot. The trip is a little more expense as a result but not outrageous--$80 per person. There is no reason to hang around Nazca longer than necessary and it is directly on the route to Cusco so after a two hour stop over, it is on the bus again heading for Cusco. But one should not go directly there. One should stop next in Abancay. This town is the gateway to the Santuario Nacional Ampay. Ampay was my third most favorite place in Peru. It is in the humid Andes and the hiking is fantastic although at better than 8000 feet, hiking is a chore and exhausting. The birding here is great with two specific rarities to find--Apurimac Brush-finch and Apurimac Spinetail. Lots of hummingbirds besides.

When we found out that it would be a four day trip to Machu Pichu, we decided to skip it and head for Puno and Lago Titicaca. We scheduled a trip to Reserva Nacional Titicaca which was quite an adventure. We had to take a 5:00 am collectiva to the small town of Huata where we were to be met at 6:00 am by the park naturalist. We were met by him at 7:00 am on a motorcycle. He took one of us and than the other on his cycle to the park headquarters over a very bumpy trail that went through plowed fields. No place to put our feet except to sort of drag them on the ground. When we were all there, the naturalist put a 25 hp outboard into a wheelbarrow, gave me a 10 foot pole to carry and off we went to the lake shore. The boat was about 20 feet out in the lake and we had to take off our boots, roll up our pant legs and wade out to it. Surprisingly, the lake was not cold even though it is at 11,800 feet. Once we were all in the boat it was off to find the Titicaca Grebe, another flightless grebe that is found only in this one place. We saw several.

Our final stop was Colca Canyon and the town of Chivay. The canyon is famous for its Andean Condors. See photo. On a trip to Peru, it is not to be missed. We saw about 20 condors rise out of the canyon as the morning sun warmed up the thermals. Also saw about 300 gringos watching the condors rise out of the canyon.

Asset Allocation for the Future

Asset allocation strategies are based on simulations of past performance. The theory is that the future will mirror the past. If only that were so, life would be so much more simple. The world is changing and if one is to be a successful investor one is going to have to change with it. In the past a conservative allocation strategy has been to allocate about one half of ones assets to fixed income investments and about one half to equities. The assets allocated to equities have generally been recommended as being 75% invested in US equities mostly to large cap equities and perhaps 25% to foreign equities or perhaps even less. The logic behind this distribution is that fixed income is a more stable investment than equities tend to be and US equities are more understandable than foreign equities and better regulated.

Of course no one can predict with any certainty what the future will hold, but one can certainly make some reasonable postulates based on trends that are apparent.

Trend #1 US budget deficits are increasing rapidly with virtually no end in site requiring the government to borrow more and more money.

Trend #2 Production is leaving the US for less expensive economies.

Trend #3 Economic development is shifting from the western world to the countries of the east.

Trend #4 Many US corporate CEOs are more interested in feathering their nests than in managing a thriving business.

These trends suggest that interest rates will rise dramatically in the future as the world's largest borrower runs out of people willing to risk lending money that most likely will not be repaid. The world economic shift taking place suggests that future investment options should also shift with them. And finally they suggest that one should avoid investing in companies paying their CEOs extravagant salaries and bonuses. They do not have their investors' best interests at heart. They have their own best interests at heart.

Although these trends appear almost self evident, nothing in this world is deterministic. Everything is probabilistic. There is always a chance that things might not be as they seem. And there is always the chance that things might change. Supposing for example that the US government were to pass a new tax law taxing incomes of over $1,000,000 at a 90% tax rate. Such a change might also change the management styles of many US corporations.

So the question is what should an asset allocation look like for the future world economy. To me it seems that one should allocate more assets to equity investments than has previously been recommended. For a conservative investor that would suggest no more than 20 to 30% in debt instruments if that much. Looking towards the future debt instruments seem to be an investment that will not fare very well. For a less conservative investor they might be avoided all together. One might ask why as much as 30% for a conservative investor if in fact interest rates are expected to rise. Why not avoid them all together? Well, the problem is that during periods of rising interest rates equities tend to perform even worse than debt instruments. Most corporations run on borrowed money, not all but most; and if borrowing costs increase their profits suffer as a result. Banks will be especially vulnerable because they borrow short term to lend long term and if they have lent a lot of long term money at 5% interest and they have to pay 6% short term, one can imagine what the impact will be. Another consideration is if one is investing in debt instruments one should avoid the longer term instruments--those over about 5 years in duration. The longer term debt instruments will be the ones that suffer the most during a rising interest rate environment.

The remaining question becomes how should one invest ones equity allocation. Certain companies in the US will do much better than others in the future. Companies with a strong balance sheet will be at a distinct advantage over those loaded with bank loans and short term debt. Those that had borrowed long term at previously low interest rates will also be at a distinct advantage. Companies with a large amount of foreign sales will also be at an advantage as they convert foreign currencies back into US currencies and as they service economies growing more rapidly than the US economy.

What are some examples of these types of companies? Coca-Cola is one such example. More than 75% of sales is outside of the US. Long term debt of the company is less than 20% of total capital. 3M is another such company. 64% of sales is outside of the US. Long term debt is less than 30% of capital. Multinational companies should be relatively safe investments if not exciting. A non-US company of this type is Nestle, a Swiss company. The question of what percentage of ones assets should be invested in these types of companies is open to some speculation. Perhaps 50% of ones equity portion, perhaps more or less. Despite what the future holds these type of companies should do well provided they continue to have good management.

The Asian countries, Latin American countries and Australia are those where future growth is most likely to occur. Some companies in these countries are traded in the US. Another option is to invest in an index fund or mutual fund that invests in these countries. There are many to choose from.

Personally, I am not in favor of many index funds as investment vehicles. They have one glaring flaw. That is that most are capitalization weighted which means that they are not a diversified investment option. Index funds concentrate most of ones investment in a few very large capitalized companies. But they are an option. On the other hand mutual funds also have one glaring flaw. They have to pay realized capital gains annually on which one is taxed. Index funds generally do not suffer greatly from that flaw.