The Future for Investors
Page 26
While there are only a few dividend-related index funds available today, I am certain that as more investors learn of the power of dividends, there will be many more such investment vehicles in the future.
TABLE 17.2: MEMBERS OF DOW 10, DOW CORE 10, S&P 10, AND S&P CORE 10 DIVIDEND STRATEGIES IN 2004
REAL ESTATE INVESTMENT TRUSTS (REITS)
Real estate investment trusts are companies that purchase and manage real estate or real estate loans. These trusts are not taxed as long as 90 percent of their net operating income is passed on as dividends to investors. For this reason, REITs are very high-yielding stocks. As of this writing, their yield is more than three times the 1.7 percent dividend yield on the S&P 500 Index.
Real estate, especially owner-occupied homes, is normally considered a separate asset class from corporate equity. However commercial, industrial, and multifamily residential properties are assets of considerable value that have publicly traded securities. As of the middle of 2004, publicly traded REITs owned more than $400 billion of the nearly $4 trillion worth of commercial real estate. The equity market value of these REITs is about $225 billion.
I believe that REITs should be a part of a well-balanced equity portfolio, especially one with a bias toward high-dividend stocks. There are many different index fund products, such as Vanguard’s REIT (VGSIX) and two separate exchange-traded funds, iShares Dow Jones U.S. Real Estate Index Fund (IYR) and the streetTRACKS Wilshire REIT (RWR).
International
I have spoken of the dramatic shift in the relative wealth of the developed and developing world that I expect over the next half century. In the last chapter I recommended that investors have a substantial portion of their assets in an indexed world portfolio. For dollar-based investors I recommend 60 percent be in U.S.-headquartered firms and 40 percent in non-U.S.-based firms.
The evidence is strong against overweighting firms that are based solely in fast-growing countries, as these stocks are especially vulnerable to the growth trap. However, I do believe that firms that have committed to the global economy should be especially attractive to investors.
Table 17.3 is a list of the twenty largest non-U.S.-based firms that derive a substantial portion of their operating income from many different countries. One choice for investing in these global firms would be to buy the Standard & Poor’s Global 100 exchange-traded fund (100), which replicates the performance of 100 multinational companies. This index chooses large-cap firms based around the world whose businesses are global in nature and who derive a substantial portion of their operating income from many different countries. Currently the annual fee for this fund is 0.40 percent a year. Another global index is the Dow Jones Global Titans (DGT) 50 Index, a capitalization-weighted index of the fifty largest multinational companies.
TABLE 17.3: TWENTY LARGEST NON-U.S.-BASED FIRMS, RANKED BY MARKET VALUE, SEPTEMBER 2004
In 2004, there was not yet any company based in China or India on this list. But it is only a matter of time before firms of China (such as China Mobile, Hutchison Whampoa, the Hang Seng Bank, and China Petroleum) and India (such as Infosys, Reliance Industries, Wipro, and others) join these global giants.
Dividend and valuation criteria are also important for international firms. In Part 3 we spoke of the importance of dividends to the corporate governance process. Since international standards of corporate accounting are so diverse, it is important to have tangible evidence of the profitability of firms. Dividends present just such evidence and are as important for foreign-based firms as they are for firms headquartered in the United States.
It is also critical that investors avoid the growth trap when buying international stocks, especially those from emerging countries. Investors should not choose the fastest-growing firms without attention to the price paid. No matter how fast firms are growing, there are limits to valuation. As always, the quality of the management and its commitment to expand those products within the company’s core competencies will always be a critical criterion for investor success.
Valuations
If anyone doubted that valuation is important when buying stocks, the experience following the Internet and technology bubbles of 1999–2000 should have erased any doubts. Valuation always matters when buying stocks.
Table 17.4 summarizes the valuation strategies that are discussed in the book. Three are based on investments in global sector funds that are linked to the energy, health care, and consumer staples industries that we described in Chapter 4. One of these strategies, introduced in Chapter 3, chooses stocks with the lowest 20 percent of all P/E ratios in the S&P 500 Index and rebalances annually. Another strategy chooses the top-performing survivor stocks of the original S&P 500, which I have called the corporate El Dorados. I also recap the investment performance of Warren Buffett, first the partnership and then Berkshire Hathaway.
TABLE 17.4: VALUATION STRATEGIES, 1957–2003
Sector Strategies
OIL
There is no question that there will be great strides in finding alternative energy sources over the next fifty years. But it is extremely unlikely that there will be a sudden reduction in the demand for oil and its distillates. The energy needs of the developing countries are huge and China and India consume more energy per unit of GDP than the developed countries of the world. That demand will clearly grow as these economies expand.
The oil sector of the S&P 500 Index has had a historical return of 12. 45 percent since the founding of the S&P 500 Index, more than a percentage point above the overall index. Stocks in the oil sector also have the lowest correlation with the other sectors of the economy. This means that oil stocks can be viewed as a hedge: if their price goes up, it hurts economic growth, particularly for such countries as the United States that import oil, but the rise in price helps petroleum producers who hold large oil reserves. This countercyclical behavior of the energy sector’s returns is a valuable diversifying tool for investors.
In addition to the large U.S.-based companies, such as ExxonMobil and ChevronTexaco, the international sector includes BP, Total of France, Royal Dutch Petroleum and Shell Trading and Transport of the Netherlands, ENI from Italy, and others.
HEALTH CARE AND CONSUMER STAPLES
The two best-performing sectors of the economy over the past half century have been health care and consumer staples. Their respective returns, at 13.76 percent and 13.36 percent annually, outpace the S&P 500 Index by more than two percentage points per year. In Chapter 3 I showed that 90 percent of the best-performing stocks—our corporate El Dorados—have come from those sectors.
The communications revolution makes it certain that consumers’ preferences will be shaped by the global media. People who travel today are struck by the similarities and not the differences in what consumers, especially those in the higher income brackets, purchase—upscale shopping malls in Beijing, New Delhi, and St. Petersburg look strikingly similar.
Many bemoan the homogenization of cultures. Yet as global travel for business and pleasure booms, individuals seek out both the unique and the familiar. The very same people who are buying the Gucci bags and Mercedes cars are showcasing their country’s own unique history and culture to foreign tourists.
Reputation and trust, attributes that brand-name producers feed on, are held in high esteem by the developing world. There is no reason why those trends should not continue. Although many brand-name firms are headquartered in the United States, the Swiss-based Nestlé and the U.K.-based Diageo, which manufactures such alcoholic beverages as Johnnie Walker, Seagrams, and Guinness, stand out.
Certainly the health care industry faces challenges. The cost of developing new drugs has skyrocketed, litigation threats abound, and price pressures from generics remain fierce. Nevertheless, the aging of the population will ensure the future demand for health care: drugs, hospitals, and nursing homes, as well as medical devices. Furthermore, the proliferation of discretionary medical treatments to offset the aging process is bound to increas
e.
Despite the hand-wringing over the high percentage of the U.S.’s output that goes to health care, it is hard to imagine that that proportion of GDP devoted to this sector will decline in coming decades. As long as the valuations in this sector do not stray far from the historical average, firms in health care are likely to outperform the market over the next fifty years. In the pharmaceutical sector, there are many foreign-based giants, such as GlaxoSmithKline and AstraZeneca from the United Kingdom and Novartis and Roche from Switzerland.
LOWEST-P/E STRATEGY
The lowest-P/E strategy sorts the S&P 500 Index each December 31 and invests in the 100 stocks (20 percent) with the lowest price-to-earnings ratios. Currently, there is no direct investment product that mimics this strategy, but I am hopeful that one will become available in the future.
The return on this strategy is slightly lower than the one using dividend yields, but it still beats the S&P 500 Index by nearly three percentage points a year, and its reward-to-risk ratio is higher. Royal Dutch Petroleum was a part of this strategy for forty-four years. There is a mix of utilities and consumer discretionary stocks that appear on the list when they are heavily discounted in the market.
The low-P/E strategy works similarly to the high-dividend-yield strategy. In the short run investors often overreact to unfavorable news, sending the price of stocks below their true values. As long as the firm is still earning profits, these overreactions will show up as a low P/E ratio, giving investors the opportunity to pick up discounted shares.
TOP SURVIVORS
The top-performing survivors include the twenty best-performing surviving stocks from the original group of the S&P 500 Index. These were the firms we identified in Chapter 3 as standing the test of time: they maintained dividend yields that were near the average for the index, slightly higher-than-average P/E ratios, and strong and committed managements devoted to expanding their markets globally. These are the tried-and-true companies that triumphed over the past half century.
It should be noted that the firms on this list do not result from an explicit strategy that investors could have pursued over the past forty-six years, since it presupposes that one knew in 1957 what the twenty best-performing survivor firms would be. However, it does suggest what returns investors could realize in the future if they are successful in seeking out the tried-and-true firms described throughout this book.
BERKSHIRE HATHAWAY
My list would not be complete without adding Warren Buffett’s investment vehicle, Berkshire Hathaway. It is noteworthy that Buffett started his investment partnership in 1957, the same year that the S&P 500 Index was founded. An investment of $1,000 put in a hypothetical no-cost S&P 500 Index fund would have accumulated to $130,700 at the end of 2003, for an 11.18 percent annual return, whereas $1,000 placed with Warren Buffett would today be worth more than $51,356,000, for a 26. 59 percent annual return.
Buffett has followed all the tenets of sound investment practice advocated in this book. He is fiercely loyal to his shareholders and ever mindful of valuation, and he avoids “story” stocks, IPOs, and those firms in fields outside of his range of expertise. Yet Berkshire pays no dividends. In Chapter 9 I go into great detail why the payments of dividends are not as important for Buffett’s investors as they are for other firms.
If everyone were enthusiastic about Buffett’s investment expertise, the price of Berkshire’s stock would soar above the underlying value of the assets, taking into account his superior future investment prowess. That has happened on occasion, but as the superior returns on his stock indicate, Warren continues to work his magic beyond what the market expects. But the best person to ask whether to buy Berkshire is Warren Buffett—he will honestly tell you whether he thinks it is overpriced or not.
Indexation and Return Enhancement
The first decision that you as an investor must make is what proportion of your equity portfolio should be indexed to the broad international market and how much should be devoted to these return-enhancing strategies. There is no single percentage that is right for every investor. My recommendation is that 50 percent of the equity portfolio should be devoted to an internationally indexed portfolio and 50 percent should be devoted to these return-enhancing strategies. But the exact proportion will depend on a number of factors specific to the particular investor.
One of those factors is taxes. Because many of the return-enhancing strategies have a higher dividend yield and realize more capital gains, the tax status of the account—whether it is taxable or tax-sheltered—is an important factor. Return-enhancing strategies are generally better suited for tax-sheltered accounts. Although this recommendation is less important today, after recent congressional tax reform that has lowered the tax rate on dividend income, many investors still wish to realize capital gains in a tax-sheltered account.
Another important factor is investors’ comfort level. No strategy can guarantee superior performance, and it is virtually certain that there will be periods of time when such strategies will underperform the market. If those periods would make an investor uncomfortable, then a lower fraction of the total portfolio should be devoted to these strategies and a higher fraction to indexation. These are issues that must be decided by each investor in conjunction with his or her financial planner. Remember that it is impossible to achieve better-than-average returns without taking some risk. Even straight equity indexation will, at times, underperform the fixed-income assets. One of the reasons stocks have returned so much more than bonds over history is the reluctance of investors to take this risk.
The Total Equity Portfolio
We are now ready to summarize the advice given in Chapters 15 and 16. These recommendations apply only to the stock allocation in your portfolio.*
I do not recommend an exact allocation to each return-enhancing strategy because this depends on market conditions and the risk tolerance of the individual investor. But an allocation of between 10 and 15 percent for each return-enhancing strategy would be reasonable.
Conclusion
Forecasting financial market returns is never easy, but the next half century presents a particular challenge to those who look into the future. The world will simultaneously face two enormous forces: the aging of the rich countries and the rapid growth of the developing world.
Fortunately, these forces are working in tandem to stop the age wave from drowning future retirees in a sea of unsold stocks and bonds. The growth in world production made possible by the rapid spread of knowledge will create buyers who will support our financial markets well into this century.
The rapid pace of technological change will attract investors to firms using the latest technology to produce new and innovative goods and services. But most of the “story” stocks that arise from these new industries will disappoint investors. History has shown that those less exciting, tried-and-true firms whose managements have stuck with winning formulas and sold their products in the expanding global market will be better investments.
Because future economic growth will be robust, a strategy of indexing returns to the global equity market will no doubt serve investors well. But the strategies revealed in this book are likely to enhance investors’ returns even further. These strategies are based on the innate propensity of investors to overpay for the “new” while ignoring the “old.”
Some maintain that once these successful value-based strategies are well known, stock prices will adjust and nullify their advantage. But I disagree. Warren Buffett had it right when he said in 1985, “I have seen no trend toward value investing in the 35 years I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult.”3
Indeed, there is nothing difficult about successful long-term investing. Avoiding the growth trap and sticking with the tried and true has served investors very well in the past. And there is no reason why those strategies will not continue to serve investors well in our future.
* The proportio
n of your total portfolio that should be allocated to stocks is beyond the scope of this book (it is treated in Stocks for the Long Run).
APPENDIX
THE COMPLETE CORPORATE HISTORY AND
RETURNS OF THE ORIGINAL S&P 500 FIRMS
At the end of this appendix you will find the corporate histories and returns of each of the original S&P 500 stocks, ranked by their cumulative return from February 28, 1957, through December 31, 2003.
We first describe the twenty top-performing stocks that include all merged firms and spin-offs (with special attention to Philip Morris and RJR Nabisco), and then discuss the returns of the twenty largest stocks by market value in 1957.
Riding on Coattails: The Twenty Best-Performing Firms in the Total Descendants Portfolio
Table A1 lists the 20 best-performing firms of the Total Descendants portfolio, which includes those original firms that have merged with other firms as well as those survivor firms that remained intact. Surprisingly, fully two-thirds of the firms that make it to the top of the list do so not only because of their own success but because they rode the coattails of other successful firms. These investment successes did not require any active participation from investors; the shares of the acquiring firm were automatically credited to the shareholders of the acquired firm.