Jul

22

 Bill Miller writes in his latest commentary, "US large capitalization stocks represent a once in a lifetime opportunity in my opinion to buy the best quality companies in the world at bargain prices. The last time they were this cheap relative to bonds was 1951. I was 1 year old then, but did not have then sufficient sentience or capital to invest."

As a thought experiment, I looked at the Dow Jones 30 stocks in this way, and found that the conclusions are impressive, even if you make the extraordinary conservative assumption that there is ZERO earnings growth over the next ten years. (Remember that during the financial crisis, corporate bonds were getting hammered too, so one could not have done this analysis in 2008.)

The choice is: (1) Buy an equal-weighted basket of the 10-year debt of blue chips or (2) Buy an equal-weighted basket of the stocks of the blue chips. And hold for ten years.

Analysis of choice #1 (bonds): The average return is 3.9%. If you own this for ten years, this is your best case and assumes no defaults, leveraged buyouts, or other credit events.

Analysis of choice #2 (stocks): The current average dividend yield is 2.9% per year on the stocks. The current average earnings yield is 6.3%. So if you own the stock basket and there is no earnings growth and no dividend growth, and the economy is Japanese-like, with intermittent recessions and growth, you will still earn roughly 2.9% + 6.3% = 9.2% per year for the next ten years. (Which is remarkably close to the long-term average return for stocks.) This assumes no bankruptcies and assumes a terminal p/e which is unchanged. But it also ignores the possibility that the economy could do much much better (or much worse).

Some might quarrel that I'm double counting … when I include the dividends. So ok, let's forget about the dividends. Then, the stock basket's earnings yield is 6.3% and the bond basket yield is still 3.9%, so it's a pickup of 240 basis points per year for the risk/reward of owning stocks. Or, put another way, over a 10 year period, 10 x 2.4 = 24% … which means that the earnings yield could decline by more than 20% over the next decade and you'd still be better off in the stock market.

None of this is making me rush out to buy stocks tomorrow morning with my ample cash reserves. But for an investor in corporate bonds, this is an important result. Admittedly if stocks keep declining, it will become more pronounced, however, at some point, we'll see corporations issuing new debt and using their cash to repurchase shares … and that's what will keep this arbitrage in line.

Column1 = stock ticker
Column2 = dividend yield
Column3 = earnings yield. That is, earnings/price for the trailing 12 months.
Column4 = that company's yield-to-maturity on its 10year corp bullet bond.
Column5 = earnings yield minus bond yield.
[There is a bit of fudging because Intel has no debt, so I arbitrarily gave it a 3.2%. And I extrapolated some companies who had debt maturing in 8 years or 12 years.] Data source: Bloomberg Dividend     Earnings     10 Yr Corp     Earnings YLD Yield     Yield     Yield     minus 10 Yr Bond Yld
AA UN Equity             1.1     -5.6     5.7     -11.3
AXP UN Equity           1.7     3.7     4.5     -0.9
BA UN Equity             2.7     3.5     3.3     0.2
BAC UN Equity           0.3     2.5     5.8     -3.3
CAT UN Equity           2.6     3.8     3.9     -0.1
CSCO UW Equity        0.0     5.6     3.6     2.0
CVX UN Equity           4.0     7.4     4.5     2.9
DD UN Equity            4.5     6.0     3.6     2.4
DIS UN Equity           1.1     6.7     3.2     3.5
GE UN Equity            2.7     8.2     4.9     3.3
HD UN Equity           3.4     5.9     3.2     2.7
HPQ UN Equity         0.7     8.1     3.2     4.9
IBM UN Equity          2.1     7.6     4.0     3.7
INTC UW Equity       3.0     6.0     3.2     2.8

JNJ UN Equity         3.8     7.2     3.7     3.5
JPM UN Equity        0.5     6.5     5.1     1.4
KFT UN Equity        4.0     7.5     4.3     3.2
KO UN Equity         3.3     5.4     3.3     2.1
MCD UN Equity       3.1     6.4     4.2     2.2
MMM UN Equity      2.6     5.7     3.2     2.4
MRK UN Equity       4.3     8.8     3.4     5.4
MSFT UW Equity     2.1     7.3     3.0     4.3
PFE UN Equity        5.0     11.1     3.1     8.0
PG UN Equity         3.2     7.2     3.4     3.8
T UN Equity           6.7     7.6     4.5     3.1
TRV UN Equity        2.9     12.6     4.2     8.4
UTX UN Equity       2.5     6.6     3.5     3.1
VZ UN Equity         7.2     7.2     4.8     2.4
WMT UN Equity      2.4     6.9     3.7     3.2
XOM UN Equity      3.0     5.9     4.1     1.8

Equal Wgt Avg      2.9     6.3     3.9     2.4

Ed.: Article pictured available here: The Stock Pickers Defeat, WSJ, Dec 2008


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