Some Graham and Dodd Type Thoughts on Stocks vs. Bonds

The essence of the Graham and Dodd philosophy is to buy stocks almost as if they were bonds. The investment value metric that we use (book value plus ten times dividends) is basically a bond metric.

Bill Gross, the bond guru at Pimco, has observed that the investment return on stocks in the 20th century was dividends, plus inflation, plus 0.6% a year real. Put another way, U.S. blue chip stocks are glorified TIPS (Treasury Inflation Protection Securities).

Around the turn of the century, stocks' dividend yields of less than 2% were less than real TIP yields of nearly 3%. That's why stocks have done nothing for a decade, because they weren't competitive on a risk adjusted basis.

The relationship is somewhat more reasonable now, with stock yields just "wide" of Treasury yields, and way above TIP yields. The respective yield premiums are now meaningful (many stocks beat straight bonds on inflation protection, and TIPs on yields).

Even so, we expect U.S. stocks to eventually lose 70% of their 2000 peak in real terms as they have done in the past. (The 2007 peaks were nominally higher than in 2000, but actually lower, after inflation.)

This could happen in one of two ways. The 1930s model involved nominal declines above 80%, which went back into the 70%s after the accompanying deflation.

The 1970s model involved inflation. Nominal stock values stayed flat for 18 years, during which time the subsequent inflation eroded the real value by more than 70%.

The market goes up about four times (in real terms) over a good 18 year cycle, and then loses most of that back (almost 75%) in the bad 18 years.

So expect a continued erosion of most of the gains of 1982-1999. A "strong" stock generation such as that is being followed by a weak stock generation from 2000-2018(?) to pull back the average annual real capital gain to Bill Gross 0.6%. The point is, you get to keep any dividends that are paid in the meantime.

The U.S. blue chip market is like a sine wave, not an upline. It basically hovers around 0% (or if you prefer, 0.6% a year) real. But values range from -1 to +1, causing booms and busts.

Therefore, we feel much better with a stock that has a dividend, providing some income. Then it is much like TIPS (Treasury inflation protected securities). If dividends are non-existent, then our proprietary investment value metric is just equal to book value. Then we try to buy such a stock as if it is a zero coupon bond; at as deep a discount as possible...

Bank stocks often meet this criterion, at least nominally. But we'd be very careful with them, because we're not at all sure of the sustainability of their dividends, or for that matter, of their book values, given the large write-ups and writedowns of assets.

We were more successful with chemical stocks earlier this year. Ashland Chemical was at half of book value in the mid-20s, when we sold it, but we were able to buy it for less than 8. Dow Chemical was also in the single digits when we bought our last batch. Dupont sometimes sells for investment value; $8 a share of book value, plus ten times its dividend takes you to the low $20s.

Other areas of interest are tech stocks. From time to time, at the bottom of their cycles, they sell for less than book value. Current and former holdings include Agilysis (AGYS) and Celestica (CLS).

Disclosure: Still long AGYS. No longer long ASH, CLS, DD, or DOW.

Comments

[Alex Trias:]

Interesting article, although I'd be nervous about relying on the TIP vs. stock analogy. As at least one commentator pointed out, stocks are riskier than Treasuries, so there is a potential apples to oranges comparison problem you have. Second, you haven't accounted for corporate growth rates. Investing in a company because it has a low price to book ratio is all fine and good - provided the shareholder equity is growing, rather than shrinking, over time.
Third, dividends can change based on corporate policy - companies might opt to scrap dividends for buybacks, for instance - sometimes for reasons having nothing to do whatever with corporate earnings. If you want to value a company, you might want to at least take corporate earnings into account somewhere in your equation.

Aug 13 10:46 AM

[_richard_:]

Look at Shiller's data--just google "Shiller" and "data" and you'll find it.

Calculate--as he does--price over average 10-year, inflation adjusted earnings. You do this because earnings tend to be sloppy--they drop too much in a crisis, grow too much in a bubble and can be managed by companies, at least for a few years. Adjusting for inflation and taking a ten year average moderates this.

If you do this, you'll find prices are still quite high.

But wait, with a spreadsheet of data going back to the 1870s, you can do more. For any given month, figure out the PE and then calculate the real return over twenty years--accumulate for dividends reinvested and stock gains and then discount for inflation. Then decile the data by PE. What you'll have is a decent estimate of real return given the current PE.

If you plot the deciles vs return, you'll find there is an abrupt discontinuity between (P/10 year E) at 15.5 and (P/10 year E) at 17.5. The first should give a real return of 4% over inflation, the second a real return of 0% over inflation. Shiller's Price / ten-year earnings today is 17.55. And note that TIPS, today, return a real return of more than 2%.

Aug 13 11:04 AM

[Robert Mart...:]

Graham & Dodd:
As you noted, we are headed into a period of lower stock returns. Of the scenarios you highlighted, I believe we are headed into the 1970s, not the 1930s. Therefore, stock selection should emphasize firms with pricing power and global demand, and client portfolios should be hedged against inflation.

Today I noted nine ETFs to hedge against inflation and a falling U.S. dollar. These include commodities, precious metals, TIPs and WIPs:
seekingalpha.com/artic...

Thanks for the article,
Rob

Aug 13 12:43 PM

[mbkelly75:]

Interesting way to look at it and one that I had not thought of (or remember doing so, anyway) in over 50 years of investing. Well written and clearly explained. A few points that I thought of:
1) 1/3 of the portfolio in Bonds works best for me over the years. I round it up to 34% and check to see if the portfolio as a whole needs re-balancing every 2 weeks.
2) Inflation has averaged 3% over the last 80 years so dividends going up an average of 5% does well enough at taking care of it and turning a profit also, even without re-investing them as they come in.
3) Focus on dividends that are RAISING their dividends for 5+ years - not just paying a dividend. They have a MUCH better return (8.92% to 6.2 % average annually) over time and are MUCH more reliable in general.
4) Investing in ANY stock that is 20% or more discounted from Price/Book Ratio, Price/Cash Flow, or a P/E below 10 (I prefer 7 or less P/E) can be a good idea. It is a contrarion indicator that works very well over time. I prefer to use it as just one of several, but it can be used all by itself if you have more money than time.
5) Of the 3, P/Cash Flow works best for industry stocks. You can simply pick 30 or 40 stocks that are the lowest in each of their industries and dwarf returns over the S&P. Holding for 5+ years simply allows them to continue gaining value so it works very well as a buy-and-hold strategy.
6) That growth should be a part of this can be solved easily by using a PriceEarningsGrowth Ratio instead of just the PE is much better overall. 0.50% or less is a Buy, from there to 0.65% is hold or buy, from there to 1% is probably hold and 1% and up indicates that the stock is either fully valued or over-valued.

Aug 13 02:09 PM

[Living4Divi...:]

That's a beautiful quote, Oldman.


On Aug 13 09:20 AM oldman wrote:

> U.S. Treasuries offer what James Grant refers to as "return-free
> risk".

Aug 13 02:17 PM

[whidbey:]

Will return-free risk is apt for Treasuries, but factually there is a place for fixed income, maybe IG bonds from blue chip corps. They are a good place to hold money today and during down markets they do appreciate mighty some times. Keep some at all times.

Rule I:a well diversified "allocation" between the growth sectors (with an eye to dividends) during rally is the key to wealth. Be in cash when the indexes move below the 200 day MA.

Rule II, selling a stock on over valuation is hard, but it is required. Heritage stocks don't exist.

Rule III Active management of ones portfolio is required.

Aug 13 05:47 PM

[birder:]

There is a difference that you neglected to mention. That is the tax treatment of stocks vs bonds. With the preferred tax treatment of capital gains and currently dividends too, the in your pocket returns of stocks are greater than bonds.

Aug 14 08:32 AM

[woofus:]

I'd be more inclined to buy TIPS if the figures to compute the bonds weren't calculated by the government...who has a vested interest to keep interest paid as low as they can get away with!

Aug 14 09:12 AM

[Boubou:]

I like this article and tend to believe it. My investment era stretches from the year 2000 to my retirement just lately. During that time no equity situation managed by the gods of fund management did any good. The same applies if you take a 2 decade view also. If you add in inflation and currency losses it was more than a disaster.
Fortunately I decided to sell all the funds and buy my own dividend stocks and and more than my share of bonds and preferreds.
So I no longer have to watch hotshots spending all my profits on futile acquisitions ,giant bonuses, and fees, and I can pay the bills.

Aug 14 10:08 AM

[jarco:]

Failure to look at the underlying assets of a company's bonds or stocks is a missing ingredient here, Continuity of dividends is highly dependent upon steady uninterrupted cash flow for the business. Stock or bonds of companies with little or no hard assets (oil, raw materials, power plants, power and/or communicatiomns distribution networks, etc.) are too risky.

Aug 14 10:23 AM

[bobbobwhite:]

I agree about buying low PEG but add one more thing: I look for the best performing company in its industry along with a low PEG, but maybe not the lowest. Sounds conflicting at first read, I know, but many times just buying the lowest PEG does not get the best performer over time, as PEG is a forward estimate while I have found that consistent, outstanding past performance is actually more important in determining future performance. If both past performance and future PEG projections are good, then it will more than likely be a better choice than choosing it by the lowest PEG alone.


On Aug 13 02:09 PM mbkelly75 wrote:

> Interesting way to look at it and one that I had not thought of (or
> remember doing so, anyway) in over 50 years of investing. Well written
> and clearly explained. A few points that I thought of:
> 1) 1/3 of the portfolio in Bonds works best for me over the years.
> I round it up to 34% and check to see if the portfolio as a whole
> needs re-balancing every 2 weeks.
> 2) Inflation has averaged 3% over the last 80 years so dividends
> going up an average of 5% does well enough at taking care of it and
> turning a profit also, even without re-investing them as they come
> in.
> 3) Focus on dividends that are RAISING their dividends for 5+ years
> - not just paying a dividend. They have a MUCH better return (8.92%
> to 6.2 % average annually) over time and are MUCH more reliable in
> general.
> 4) Investing in ANY stock that is 20% or more discounted from Price/Book
> Ratio, Price/Cash Flow, or a P/E below 10 (I prefer 7 or less P/E)
> can be a good idea. It is a contrarion indicator that works very
> well over time. I prefer to use it as just one of several, but it
> can be used all by itself if you have more money than time.
> 5) Of the 3, P/Cash Flow works best for industry stocks. You can
> simply pick 30 or 40 stocks that are the lowest in each of their
> industries and dwarf returns over the S&P. Holding for 5+ years
> simply allows them to continue gaining value so it works very well
> as a buy-and-hold strategy.
> 6) That growth should be a part of this can be solved easily by using
> a PriceEarningsGrowth Ratio instead of just the PE is much better
> overall. 0.50% or less is a Buy, from there to 0.65% is hold or buy,
> from there to 1% is probably hold and 1% and up indicates that the
> stock is either fully valued or over-valued.

Aug 14 11:04 AM

[GadflyOnThe...:]

My investment history goes back to 1966, so I've been through the 1970s (which was indeed ugly), through 1987 (which was scary), through the dot.coms (being in Silicon Valley, I've had my dotcom successes and failures). I learned from these events, as well as profited from them and their subsequent rebounds.

I believe that when comparing stocks and bonds, it is not that stocks are directly comparable to bonds as investments, but rather, that stocks, because of their secondary standing to bonds, should pay enough premium over the return of bonds to warrant investing in them. If you cannot, after research, justify the possible rate of return on a company's stock vs. let's say, a treasury, then it is time to move onto another company.

That said, my background being international investments, many of you may be missing some excellent opportunities by limiting yourselves to the United States. The US investment market makes up 40% of the world investment market. Look to the rest of the world for your next investment oysters. There are some excellent opportunities out there. I follow Sir John Templeton's mantra: There is always a bull market somewhere. I also follow his lesson: "Buy during times of maximum pessimism", which is similar to the Rothchilds' "Buy when there's blood in the streets."


On Aug 14 10:08 AM Boubou wrote:

> I like this article and tend to believe it. My investment era stretches
> from the year 2000 to my retirement just lately. During that time
> no equity situation managed by the gods of fund management did any
> good. The same applies if you take a 2 decade view also. If you add
> in inflation and currency losses it was more than a disaster.
> Fortunately I decided to sell all the funds and buy my own dividend
> stocks and and more than my share of bonds and preferreds.
> So I no longer have to watch hotshots spending all my profits on
> futile acquisitions ,giant bonuses, and fees, and I can pay the bills.
>
>
>

Aug 14 11:27 AM

[mbkelly75:]

Some good points have been made. I would point out that while I believe that the PEG ratio is better than the PE - it is not the only ratio that I use and I do not use the lowest PEG but simply look for one within the correct range. Earnings have been so messed with over the years since Enron - I have found that a Price/Sales Ratio to be more useful overall. I look for Price/Sales to be less than or = to 1.0 and lower is better. I have also found that a Quick Ratio that is equal to or higher than 1.0 is a good ratio, and the Relative Strength Ratio should be higher than 89%. This ensures that the company is doing better than 90% of the other companies.

Using Price/Sales points out just how many stocks can be 7 or less with the PE Ratio and still be over-valued. It is quite an education and makes clear what stock is a good buy and which stock is not.

BYW - Sir John Templeton and the Baron were both wise men and I believe that they were quite right. I have have done quite well following the Old Masters.

Aug 17 07:50 PM

[Robert Mart...:]

Graham & Dodd:

The current downcycle is marked by poor job creation despite massive monetary and fiscal stimulus. I describe this in detail in "The Deflation of the American Dream" seekingalpha.com/artic.... This scenario is quite likely to cause protectionism, and trade conflict with China seekingalpha.com/autho...

I agree with your focus on dividend stocks, and I include them in my inflation basket. seekingalpha.com/artic... I would emphasize basic materials and energy, since these will be key beneficiaries of the global reflation rally.

Rob

Sep 29 12:17 PM

[Michael Clark:]

G&D: Our years of expansion/contraction are almost exactly the same. The stock market will under-perform 2001-2019. Prepare to get bullish around 2018-19 -- although there are always trading opportunities long and short in any market.

The 1929 high was not surpassed until 1954...the 1966 high of 1,000 on the Dow proved to be a stubborn resistance level that wasn't successfully taken out until 1983.

Sep 29 12:50 PM

[Graham and ...:]

More than that; we didn't regain the 1966 high in inflation adjusted terms until 1995, 29 years later.

(That was 1958, 29 years later for the Dow to exceed the 1929 high in inflation adjusted terms.)

Maybe 2029 for the Dow to exceed the 2000 high in inflation adjusted terms.


On Sep 29 12:50 PM Michael Clark wrote:

> G&D: Our years of expansion/contraction are almost exactly the
> same. The stock market will under-perform 2001-2019. Prepare to
> get bullish around 2018-19 -- although there are always trading opportunities
> long and short in any market.
>
> The 1929 high was not surpassed until 1954...the 1966 high of 1,000
> on the Dow proved to be a stubborn resistance level that wasn't successfully
> taken out until 1983.

Sep 29 02:39 PM

[Graham and ...:]

What I think you mean is that the inflation-fighting "capital gain" on stocks compounds tax deferred (as is the case with TIPs), while the whole yield on bonds is taxed the same year.


On Aug 14 08:32 AM birder wrote:

> There is a difference that you neglected to mention. That is the
> tax treatment of stocks vs bonds. With the preferred tax treatment
> of capital gains and currently dividends too, the in your pocket
> returns of stocks are greater than bonds.

Sep 29 02:44 PM

[Graham and ...:]

Ben Graham would agree with you.


On Aug 14 10:23 AM jarco wrote:

> Failure to look at the underlying assets of a company's bonds or
> stocks is a missing ingredient here, Continuity of dividends is highly
> dependent upon steady uninterrupted cash flow for the business. Stock
> or bonds of companies with little or no hard assets (oil, raw materials,
> power plants, power and/or communicatiomns distribution networks,
> etc.) are too risky.

Sep 29 02:47 PM

[Graham and ...:]

Stocks have (theoretically) the same inflation-fighting properties as TIPs.

Stocks are riskier than TIPS for the reasons you mention, which is to say that they require higher yields than TIPs to compensate.

This was not true in 2000, which meant that stocks were then overpriced. That explains their lousy price action over the past decade.

Stocks now offer a premium over TIPs and straight bonds. Whether it is "large enough" to compensate for risk, that remains the question.

Ben Graham thought of stocks as "bonds" with an inflation "kicker." That's the thinking here as well.


On Aug 13 09:57 AM Fund Insider wrote:

> I don't know how any professional investor can talk about dividends
> as having anything to do with the merits of one stock over another.
> Companies are not obligated to pay dividends, and when they fall
> on hard times, they cut the dividend. Stocks are not bonds, bond
> issuers have to default, a very serious step, compared to cutting
> a dividend. Stocks are NOT tips. If true that the real return is
> same as TIPS, nobody should buy any stocks at all, as you have more
> risk with no commensurate reward. Your entire analysis is based
> on the false views of dividends being like bond coupons, and pure
> index buy and hold equity investing returns (not even asset allocation
> trades).
>
> I really want to believe you, so I can move all my stocks to TIPS
>
> and sleep better at night, knowing I'll get the same return with
> less risk, but I don't think this is even close to true.

Sep 29 02:53 PM

[Graham and ...:]

"MV=PT"

I am "agnostic" about inflation or deflation, because I'm not sure whether V is falling faster than M is rising, or vice-versa.

But I am hedged both ways for the "volatility trade," and wary of ordinary stocks that lack pricing power (e.g. consumer discretionary).


On Sep 29 12:17 PM Robert Martorana wrote:

>
> Graham & Dodd:
>
> The current downcycle is marked by poor job creation despite massive
> monetary and fiscal stimulus. I describe this in detail in "The Deflation
> of the American Dream" seekingalpha.com/artic....
> This scenario is quite likely to cause protectionism, and trade conflict
> with China seekingalpha.com/autho...
>
>
> I agree with your focus on dividend stocks, and I include them in
> my inflation basket. seekingalpha.com/artic...
> I would emphasize basic materials and energy, since these will be
> key beneficiaries of the global reflation rally.
>
> Rob

Sep 29 03:06 PM