Wednesday, March 30, 2011

Dividend-Paying Stocks or High Quality Bonds?

This morning I had a good meeting with a very smart client.

Much of our discussion revolved around the outlook for interest rates, and the role that bonds should play in a client portfolio.

Although my client is part of the intelligentsia that reads Random Glenings (and so is familiar with the deflationary trends that surround us), my client believes we are heading for inflationary times.

The combination of loose monetary policy, and an undisciplined government piling on debt, will inevitably lead to inflation, said my client. His view, of course, is shared by the majority of economists and investors.

If he is right, buying a 10 year Treasury bond yielding 3.5% makes no sense if you can invest in a stock that pays a dividend in the 3% range. There are many dividend-paying stock in industries like energy, industrial and utilities would fit the bill.

The best case scenario for a bond holder, he pointed out, was that interest rates stayed around today's levels, or move slightly lower. This scenario would result in a respectable rate of return.

However, if inflation picks up even a small amount from today's levels, the real return for the bond holder will be fairly unattractive.

Buying shares of companies that pay dividends, on the other hand, at least give the investor the chance to maintain purchasing power, since presumably the value of the company would rise at least in line with inflation.

Now, admittedly, this did not happen in the 1970's, when stocks proved to be poor inflation hedges and delivered mediocre returns, but one could also argue that the starting valuation of the stock market was less attractive than it is today.

This was also the point that Warren Buffett made last week while he was traveling in India. Here was an excerpt from a Wall Street Journal article last week:

"Inflation is a very cruel tax," said Mr. Buffett, because it lowers the worth of your paper money.

He said one of the best ways to keep the value of your money growing is to invest in good businesses and companies which keep growing. That helps investors "maintain purchasing power no matter what happens to the currency," said Mr. Buffett.

He advised against buying long-term bonds of any government, because both inflation and printing of new currency lowers the value of these investments.

The problem, of course, is that most of us can't resist reacting to daily movements of the stock market.

Dividend-paying stocks might make sense for a longer term time horizon, but most of us have trouble keeping volatility in perspective when markets fall.