Seth Klarman, the author of the legendary investment work "Margin of Safety" that only ran one print edition (and thus the book sells for over $1,000 on websites like Ebay and Amazon), often encouraged investors to think like investors instead of speculators. While Warren Buffett has his analogy that encourages investors to pretend that the stock market has closed for five to ten years, Klarman encourages investors to only buy assets that would generate good returns by measuring the business performance in relation to the price paid (instead of worrying about market fluctuations in either direction).
In particular, Klarman pointed out how ridiculous the market for thirty-year Treasuries has become because no one actually goes through with holding them for thirty years:
For still another example of speculation on Wall Street, consider the U.S. government bond market in which traders buy and sell billions of dollars' worth of thirty-year U.S. Treasury bonds every day. Even long-term investors seldom hold thirty-year government bonds to maturity. According to Albert Wojnilower, the average holding period of U.S. Treasury bonds with maturities of ten years or more is only twenty days.' Professional traders and so-called investors alike prize thirty-year Treasury bonds for their liquidity and use them to speculate on short-term interest rate movements, while never contemplating the prospect of actually holding them to maturity. Yet someone who buys long-term securities intending to quickly resell rather than hold is a speculator, and thirty-year Treasury bonds have also effectively become trading sardines. We can all wonder what would happen if the thirty-year Treasury bond fell from favor as a speculative vehicle, causing these short-term holders to rush to sell at once and turning thirty-year Treasury bonds back into eating sardines.
Let's ponder the question: What would happen if someone actually held a Treasury bond bought today for the next thirty years? Right now, the thirty-year bond rate is at 3.10%. That means that if you make a $10,000 investment, you will receive $310 this year, next year, the year after that, and so on. Of course, you will never get a raise. With inflation running at about 3.5% annually, you will gradually lose purchasing power each year as that $310 will buy you less and less in terms of purchasing power.
Over the course of those thirty years, you will receive $9,300 in interest payments. Nominally, you turned a $10,000 investment into $19,300 over thirty years. The problem, of course, is that you have to take inflation into account. The inflation rate of 3.5% annually is greater than the 3.10% interest rate that will represent your total returns. The problem is that, in thirty years, it will take slightly over $28,000 to maintain the same purchasing power as $10,000 today (assuming the 3.5% annual inflation rate). That means that someone who buys a thirty year Treasury bond today and holds for thirty years will actually see his purchasing power decline by 30% as the reward for investing for thirty years. Investing is the act of putting aside money today for more purchasing power tomorrow. Unless we have long-term inflation rates below 3.10%, the Treasury investor will grow poorer and poorer with each passing year.
Now let's compare owning a thirty-year Treasury bond to a basket of some of the most stable dividend stocks in corporate America: Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), Pepsi (NYSE:PEP), and Chevron (NYSE:CVX). Chevron has raised dividends by 8.5% annually over the past decade; Pepsi has raised dividends by 13.5% annually over the past decade; Johnson & Johnson has raised dividends by 13.0% annually for the past ten years; Procter & Gamble has done it by 11.0%, and Coca-Cola by 10.0%.
With some ease and perhaps a bit of patience, you could create some buy limit orders to buy equal amounts of these five companies with a starting yield of 3.10%. And even if each of these companies offered future dividend growth below the high rates of the past decade, 7% annual dividend growth ought to be a reasonable assumption from these five companies.
Let's look at what happens to someone that made equal investments of $2,000 into each of these five companies ($10,000 total) with a starting yield of 3.10% that grew at 7% each year. Although this investor will receive the same $310 in the first year as the Treasury investor, he will receive a boost to $331 in the second year. In the third year, he'll get $354. And by year thirty, this dividend growth investor will be receiving $2,359 in annual income while the Treasury bond investor is still getting $310 annually. With each passing year, the dividend investor will be getting richer while the bond investor will be getting poorer (in terms of purchasing power). This is because the dividend growth investor is increasing his power relative to inflation by 3.5% each year, while the Treasury bond investor is earning static income that is losing 0.4% in purchasing power each year.
I did not bring up this example as something to take literally. I'm not suggesting that you only own a basket of five stocks, nor do I think it is wise to extrapolate dividend growth from a particular company for thirty years because it is hard to be accurate about anything given a third of a century time span. Rather, the point is this: you should be able to make a comprehensive dividend growth portfolio that grows income by at least 7% annually (every example listed here has done at least that for the past decade), and with some common sense monitoring, this should be the kind of dividend growth that you should be able to pull in without breaking a sweat.
I will consider this article a success if I encouraged you to think of risk in relation to purchasing power, rather than the seeming security of stable, guaranteed payments. Most people (with good reason) automatically associate the Treasury bonds with "safety." But if you actually hold one of those bonds for thirty years, it's on the short list of the most unsafe investments you can make because you are guaranteed to lose money in terms of purchasing power (unless long-term inflation runs below 3.10%). That is what makes those guaranteed payouts deceiving. A comprehensive collection of dividend growth stocks, however, are much safer because you are likely to achieve growth at a rate that is higher than inflation. The price is that you must tolerate daily fluctuations in your net worth that can jolt the investor of his path. When you shift your focus from guaranteed payouts to the likelihood of gains in purchasing power, you can see what makes dividend stocks so attractive as a long-term strategy.
Disclosure: I am long PG, JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.