The Intelligent Investor: Portfolio Policy For 2018

by: Investment Works


Benjamin Graham, the father of value investing, used to publish a revision of "The Intelligent Investor" every 5 years.

In Chapter 1, he would advice the investor on the relative allocation between stocks and bonds, based on prevailing yields and market conditions.

We apply his thought process to the conditions seen in January 2018, which are not to dissimilar from those he encountered in 1964, and evaluate his recommendation at the time.

We find that in 2018 stock investment still appears preferable to bond investment, and make the case for a substantial allocation to cash.

Benjamin Graham, the father of value investing, used to write a revision of "The Intelligent Investor" every 5 years. In Chapter 1, he would advice the investor on the relative allocation between stocks and bonds, based on prevailing yields and market conditions.

Benjamin Graham, Author of The Intelligent Investor and Father of Value Investing Benjamin Graham and the latest revision of The Intelligent Investor

In this piece, we attempt to provide similar guidance to inform investors' portfolio policy in 2018.

Returns to be expected from common stocks

In the times of Benjamin Graham, dividends were the only form a company would share profits with its shareholders. But in the last two decades, stock share repurchases have caught up and even surpassed dividend payments as the preferred instrument to distribute excess cash to shareholders.

In comparing expected income yield from bonds and stocks to assess their relative attractiveness, we shall therefore add the expected buyback yield to the expected dividend yield in the case of equities.

The last data on dividend and buyback yields for the companies in the S&P 500 (SPY, IVV, VOO) provided by S&P Dow Jones Indices is for the 12 months ended June 2017. It put the dividend yield at 1.96% and the buyback yield at 2.41%, for a total redistributed income yield of 4.37%.

Several things have changed since then:

  • The S&P 500 index has climbed 387 points, for a 16% gain.
  • Real growth and inflation have increased nominal earnings by about 2% from June 2017 to January 2018.
  • US tax reform will cut the corporate tax rate to 21% from 35% in 2018. Analysts have estimated the ultimate effect of the tax cut on corporate earnings in the range from 7% to 10%. Note that these gains are much lower than 21.5% ((1-0.21)/(1-0.35)-1) since i) only a few companies were paying the full 35% corporate rate and will be paying the full 21%, and ii) part of the benefits from the tax cut will be passed through to employees, consumers and other stakeholders, depending on market forces. For this analysis, we are going to take 8% as the boost in US corporate earnings.

Putting all together, we estimate income yield (from dividends and buybacks) as of January 2018 at 4.15% (4.37%*1.02*1.08/1.16). This figure excludes the expected one-off special dividends and share repurchases following cash repatriation from companies like Cisco (CSCO), Netapp (NTAP), Qualcomm (QCOM), Apple (AAPL), Amgen (AMGN), Oracle (ORCL), Microsoft (MSFT), Waters (WAT), Western Digital (WDC) or General Electric (GE) (given from larger to smaller overseas cash as percentage of market cap).

S&P 500 Dividend and Buyback Yields From 2014 to 2018

Dividend and buyback yields from 2014 to January 2018
(sources: raw data from S&P Dow Jones Indices, Jan. 2018 estimates and figure from Investment Works)

From the figure above, note that the income yield has been in constant decline since 2015, from 5.34% to today's 4.15%, due stock price increases, partially offset by higher dividend payments and stock repurchases (recall that the 4.15% figure includes the permanent effect of a lower corporate tax rate, but excludes the one-time benefits from tax repatriation).

Moreover, the TTM S&P 500 PE ratio sits at 26.17, implying an earnings yield of 3.82%. The 8% increase in corporate earnings resulting from tax reform would boost the earnings yield to 4.13%, a figure almost identical to the combined dividend and buyback yield. Assuming that cash flows are near the reported earnings used in the calculation of the PE ratio, we need to be skeptical about the sustainability of a dividends and buyback as large as corporate earnings. Clearly, companies need cash every year to restore their asset base and to fund growth. Today, companies are using debt to complement free cash flow and be able to maintain or increase their dividend payments and share repurchase programs while restoring and expanding their asset base. But debt doesn't fix the underlying imbalance between input and output cash flows; it just delays its resolution.

Therefore, we are going to take 3.5% as the sustainable dividend and buyback yield at today's market prices. Furthermore, assuming average real GDP growth of 2%, average inflation rate of 2% and that stocks are currently fairly priced, we can expect stocks to return 7.5% (3.5%+2%+2%) on average on the upcoming years.

Note that in the estimation above, the 2% real annual dividend growth (or 4% nominal) is funded with the 0.65% of current markcap (4.15%-3.5%) reinvested in the business. If higher re-investments were required to fund that growth (say 1.15% of current markcap), then dividend and buyback yield would decline (to say 3.5%-0.50% = 3%) and so would expected stock returns (to 3%+2%+2% = 7%). This 7% to 8% annual total return is 1 to 2 points below the average total return since 1930, and in line with more recent decades.

Returns to be expected from high quality corporate bonds

As of December 2017, the 10-Year High Quality Market (HQM) Corporate Bond Par Yield was 3.34%. The 25-Year one, 4.01%. (The HQM yield curve uses data from a set of high quality corporate bonds rated AAA, AA, or A that accurately represent the high quality corporate bond market.)

The following chart puts together the stock income yield calculated before and the 10-Year HQM yield for the period from 2014 to January 2018.

S&P 500 Stock Dividend and Buyback Yield Vs 10-Year Corporate Bond Yields

Corporate vs stock combined dividend and buyback yields from 2014 to January 2018 (sources: raw data from S&P Dow Jones Indices and FRED, Jan. 2018 estimates and figure from Investment Works)

The attractiveness of equity income relative to bond yields has steadily deteriorated since 2015, but is not yet far from that seen in 2014 or mid 2017.

Recommended proportion between stocks and bonds

In the 1964, with corporate bonds yields at 4.5% and stock dividend returns at 3.2%, Benjamin Graham recommended a 50-50 proportion between stocks and bonds, reducing the common stock component to 25% "if he [the investor] felt the market was dangerously high", and to advance it towards 75% "if he felt that a decline in stock prices was making them increasingly attractive". Forecasting total stock returns at 7.5%, he estimated the half and half division between bonds and stocks would yield about 6% (the average of 4.5% and 7.5%).

Today, 25-Year corporate bonds yield 4% and stock dividend and buybacks, 4.15%. These figures are not far from those seen in 1964. But bonds yield today 0.5 points less than they did in 1964 while stocks yield almost 1 point more (as said before, sustainable stock income may be somewhat lower, about 3.5%, but that is still 0.3 points above dividend yield in 1964). Moreover, the benefits from cash repatriation would be reaped by stockholders, but not at all by bondholders.

If Graham was correct in his 50-50 split between stocks and bonds, two obvious conclusions would follow:

  1. In 2018, stock investment appears preferable to bond investment.
  2. If the trends in stock and bond yields seen since 2015 continue, the investor should start to shift funds from stocks to bonds in the upcoming years.

The role of cash

But was Graham correct in his 1964 call?

In 1970, corporate bond yields had climbed to 7.5%, while the dividend return on DJIA-type stocks was only 3.5%. The change in interest rates produced a maximum decline of about 38% in the market price of medium-term bonds during the 1964-1970 period.

And while Graham had warned investors in 1964 that "the price of stocks might be too high and subject ultimately to a serious decline", he did not consider the possibility that the same might happen to the price of high-grade bonds.

In the 1970 revision of The Intelligent Investor, Graham acknowledged:

Even at the lowest level [of the DJIA] in 1970 his [of the investor] indicated loss would have been less than that shown on good long-term bonds. On the other hand, if he had confined his bond-type investments to U.S. savings bonds, short-term corporate issues, or savings accounts, he would have had no loss in market value of his principal during this period and he would have enjoyed a higher income return than was offered by good stocks. It turned out, therefore, that true "cash equivalents" proved to be better investments in 1964 than common stocks -in spite of the inflation experience that in theory should have favored stocks over cash.

He realized in 1964 that stocks were expensive by historical standards. And that bonds were fairly priced relative to stocks. But in a rare misjudgment, he did not -at least explicitly- take those two observations to the evident corollary that bonds were also expensive by historical standards.

The mistake was not so much in the answer as it was in the question. He answered the question of which proportion of capital shall be allocated to stocks and which to bonds, letting aside an entire asset class: cash and cash equivalents.

When stocks are expensive and bonds are expensive (by historical standards), it is cash that is cheap. Value is in cash, and (value) investors should hoard it to put out the bucket, not the thimble, the day it rains gold.

Conclusion and future updates

Are we to experience high inflation or a similar increase in interest rates in the next 6 years? It is possible, but we don't know.

What we do know, however, is:

  1. That stock investment appears preferable to bond investment.
  2. That although stock dividend and buyback yields are at about historical average levels, stock earnings yields are at historically high levels.

In other words: bonds are expensive relative to stocks, and stocks expensive relative to past (and most likely future) times.

The takeaways are clear:

  1. In January 2018, the simplest choice is to maintain a 50-50 proportion between stocks and cash equivalents, reducing the common stock component to 25% if the investor felt the market was dangerously high, and advancing it towards 75% if he felt that a decline in stock prices was making them increasingly attractive. We see no case for long-term bonds.
  2. If bond yields continue to increase its attractiveness relative to expected stock returns, the investor should start to shift capital from stocks to bonds (this may start to happen by the end of the year, or into 2019 or 2020).
  3. If bond yields increase in absolute terms, the investor should start to shift capital from cash equivalents to bonds (this may start to happen by the end of the year, or into 2019 or 2020).

Disclosure: I am/we are long AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.