Friday 6 December 2019

It's the burning investor question of the day: 'Can stocks be safer than bonds?'

FELIX Salmon, an excellent columnist with Reuters, had a good column this week posing one of the key questions that investors are asking themselves at the moment; can stocks be safer than bonds?

Anybody crazy enough to invest solely in Irish shares and bonds would answer in the affirmative, but what is the story globally?

At the moment, the market says the world's most investable ultra low-risk assets are US treasury bills and German euro bonds, but what about stocks like Johnson & Johnson? The US company's dividend yield is 3.39pc -- higher than the 10-year Treasury rate of 3.2pc. It's international, and it has very little leverage: total debt to equity is less than 30pc.

Such stocks have one clear advantage over any kind of bonds: they're much less prone to being eaten away by inflation. If you own a company, then you're selling things that tend to go up in price in line with inflation. And if you own a diversified group of companies, then your inflation risk is much lower than if you own a set of liabilities that are fixed in dollar terms.

A final advantage is that companies that are broadly diversified by country stocks should offer decent protection against a plunging currency.

The problem, as Salmon notes, is that when times get tough, companies need to cut their dividends. Just when investors want that income most, it is prone to disappear.

Johnson & Johnson might be paying out 57 cents per quarter right now, but that dividend has been growing at an impressive rate -- it was just 5 cents 20 years ago. With hindsight, buying a stock that was going to see its dividend grow by 12pc per year would indeed have been a very good idea. (Johnson & Johnson stock was trading at $7.03, adjusted for splits, 20 years ago; it's $67.30 today.)

But would you have sold the stock by now if you'd bought back then? Another way of posing this question is to ask whether you should sell stocks if and when their dividend yields drop below the 10-year Treasury?

Johnson & Johnson was certainly there -- a decade ago, its dividend yield was just 1.4pc, when the 10-year Treasury was yielding 5.4pc. In fact, over the past 10 years, you would have been better off in long-dated Treasuries than in Johnson & Johnson.

More generally, if Johnson & Johnson's dividends can go up enormously over time, they can go down enormously over time as well. Companies fail. And on an individual-company basis, there's no dividend in the world that is remotely as dependable as the coupons on Treasury securities. Even on a diversified basis, dividends are -- and should be -- cyclical, going up in good times and down in bad times. Which is the exact opposite of what you'd ideally want from an investment. Dividend cashflows have a nasty habit of being "dependable", in other words, only up until the point at which you actually want to start depending on them.

BP and Shell between them account for half of the dividends paid by UK companies every year. It seems quaint, but there really are a lot of far-from-wealthy people in the UK who live off their dividend income, and those people constitute a surprisingly large part of BP's shareholder base. If BP suspends its dividend, the only way they can get money from their stock is by selling it.

These small investors didn't care about volatility of principal at all, so long as they kept on getting their dividends. But the minute that the dividend disappeared, the volatility of the principal became hugely important. And even if you didn't need to sell your BP shares when it suspended its dividend, any dividend-stock investor would feel a bit of a chump holding on to shares that weren't paying a dividend at all.

On top of all that, there are good reasons why companies should not declare large dividends, and should spend the money on stock buybacks instead.

Why force all your investors to declare dividend income, when buybacks are an elegant way of returning money to the shareholders who want it, while allowing those who don't to benefit from a smaller float?

So long as capital gains taxes are lower than income taxes, a lot of shareholders will be quietly encouraging companies to go the buyback route rather than the dividend route.

So if you're looking for the world's most investable ultra low-risk asset, Salmon concludes that a portfolio of high-dividend stocks is necessarily the way to go because any asset that can lose all its cashflows and half its value overnight cannot be considered "ultra low risk" no matter how sanguine you are about price volatility. And even though you can diversify, that doesn't tend to work very well during crises.

Still, there is one good thing about holding stocks as part of a low-risk portfolio: you can't kid yourself that there's no risk there at all.

Debt is treacherous, and hides its risks; with stocks, the risks are out there in the open for all to see. The paradox is that nothing would be better for reducing the amount of systemic tail risk in the economy than seeing a large number of people coming around to the idea that stocks are safer than bonds.

(This is an edited version of Felix Salmon's column called Can Stocks be Safer than Bonds?)

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