Bonds vs stocks. The question of how we allocate capital between bonds and stocks has always been an important one in developing an appropriate investment strategy. The underlying assumption in owning stocks is that, over time, they will perform better than bonds. Yet recent experience has convinced investors that the stock market is risky, while the bond market is less volatile and earns better returns. You see it in the fund flow data, with investors continuing to add money to bond funds while taking money out of stock funds.
Adding fuel to the fire is Bill Gross, the famed bond fund manager at PIMCO, who recently wrote to his clients that “the cult of equity is dying.” He argues the stock market in the future cannot generate returns of 6%+ above inflation, as it has on average for the last 100 years. According to Gross, if national wealth (GDP) only grows at 3-3.5% then the stock market’s growth of 9-10% must be alchemy or even a Ponzi scheme. Well, I disagree.
The key point missing in his argument is the ability of superior companies to earn superior returns. One needs to keep in mind that the companies in the public market are remarkably successful. Microsoft, Johnson & Johnson, and Coca Cola are just a few examples or companies that earn tremendous returns on equity (ROE). Please keep in mind ROE is a fairly simple statistic equal to net income divided by book value. In other words, it is how much money you make in a given year from $1 invested.
Suppose we have an average company in the S&P 500 that trades at $100 and has the average historical market P/E of 15x. Its earnings would be $100/15x = $6.67/share. How much wealth can this average company create over the coming year?
Let’s assume $2.50/share of this income goes to shareholders as dividends. The remaining $4.17/share is invested back in the company. What sort of return should that investment give us? Historically the S&P 500 has had an ROE of about 13%, and I will assume the cost of capital (the amount that has to be paid to the bankers and investors who lend and invest the money the company needs to grow) is about 8%. If our average company can earn 13% on that money over a 10 year period when it only costs the company 8%, then our company is creating about $6.50/share in value. (For those interested, the calculation is 4.17 x (1.13^10) / (1.08^10)). When we add the dividend of $2.50/share to the value created by the superior investment opportunities of $6.50/share, we get $9/share of total return on our $100 stock, or 9%. With the 10 year treasury bond yielding less than 2%, the 9% return from our average company looks attractive even with the higher volatility that comes with stocks.
I am not suggesting there is no place for bonds in a portfolio. For money we may need over the short or medium term, the bond market’s lower volatility makes perfect sense. But long-term money is almost always better in stocks, despite recent experience and the investing public’s current misplaced sentiment.