Friday, October 14, 2011

Investment Choices in a Low Return World

It has been said that democracy is the worst form of government except all the others that have been tried.
-Winston Churchill

When I look at the asset markets today, I am reminded of Churchill's quote.

Investors and savers face a fairly unappetizing menu of investment choices these days.
  • Stay in cash and earn nothing for the next two years?
  • Buy high quality bonds with yields at 60-year lows?
  • Buy stocks whose returns over the last decade or so can best be charitably described as mediocre?

You already know where I stand on this: I think that dividend-paying, larger cap stocks offer the best combination of income and capital appreciation potential.

Still, there is no question that stocks will continue to show more volatility than most would prefer as the world struggles with the mountain of debt we accumulated over the past decade.

The Economist has written in this week's issue about the difficult choices facing investors these days.

For example, the article cites a Deutsche Bank study on bonds:

Deutsche Bank’s study suggests that, if yields revert to the mean, investors in 30-year Treasury bonds will suffer an annualised loss of 3.3% over the next five years and 1.3% over the next ten; investors in ten-year bonds will suffer annualised losses of 4.3% and 2% respectively.

And what about commodities? Here's The Economist's view:

The problem with gold, and other commodities, is that with no yield or earnings they are hard to value. Demand from Asian countries has certainly pushed up prices; non-oil commodities have trebled over the past decade. But if the economy does start to slip into recession, commodity prices could fall very sharply; they almost halved between March and December 2008. This year they have dropped by around a fifth since February.

I could go on, but you get the idea: there are very few safe havens in today's world.

Still, as both The Economist and other analysts have suggested, buying higher yielding equities trading at reasonable valuations offer the best potential returns from a relatively meager list of alternatives.

The key, in my opinion, will be to focus on companies whose dividend is not only attractive today, but has the potential for growing along with inflation in the years to come.

Fortunately, there are numerous companies that fit the bill. Corporate America flush with cash, and margins are at record levels. Payout ratios for most companies is at historically low levels, which gives the chance for dividends to grow.