Don’t Buy The Best Performing Asset of 2010

What is the best-performing asset of 2010? It isn't stocks: The S&P 500 is about where it was at the beginning of the year. It isn't gold, either, although this asset shares one characteristic with the yellow metal: You won't receive a cent of income on it while you own it. 

The answer is zero-coupon Treasury securities, which have returned as much as 21% year to date. That's an impressive number, but it doesn't justify piling into them now. After I explain why, I'll go on to suggest some stock market alternatives.

Stripping 101
Zero-coupon Treasurys (or STRIPs) are created by separating the interest and the principal payments on a regular Treasury bond. The result is a bunch of bonds with no periodic interest payments -- just a lump sum payment at maturity. Although this is mainly a market for institutional investors, individual investors can easily participate via PIMCO's Zero-Coupon 25+Year Index Fund ETF (NYSE: ZROZ).

One of the reasons zero-coupon securities have performed so well is that they have higher sensitivity to interest rates than an ordinary Treasury bond. Thus, as interest rates have fallen, the value of the former has risen more quickly. However, buying either one looks like a losing proposition right now.

How do you win?
If you buy zero-coupon securities, two scenarios are possible (the same reasoning applies broadly to regular government bonds):

• You don't expect to hold them to maturity. In this case, the greater sensitivity to interest rates will play against you if yields rise (yields are already at historically low levels). In the near term, it's certainly conceivable that yields might fall further, but the floor is surely in sight.
• You expect to hold them to maturity, in which case you are locking in an annualized return somewhere near 4%, depending on the maturity. This amounts to a bet that inflation will be negative or near zero in the long term. Such a Japan-style "lost decade" scenario is possible but unlikely, in my opinion.

Five high-quality dividend stocks
There are better alternatives for your money at this time – and they provide an income return to boot. Some 15% of the stocks in the S&P 500 offer a dividend yield that exceeds the yield to maturity on the 10-year zero-coupon Treasury STRIP (3.37%). They include:

Source: Capital IQ, a division of Standard & Poor's.

Rising earnings and rising dividends
Furthermore, the dividends aren't static; investors can expect them to rise over time, protecting the purchasing power of the income they provide. That expectation isn't based on a hope and a prayer, either -- there are legitimate reasons to believe all of these businesses can continue to increase earnings over the coming years:

• Plum Creek Timber is the first and largest publicly-traded timber REIT (Real Estate Investment Trust). In that capacity, it's also the largest private landowner in the United States. The story here is straightforward: Timber returns are largely based on biological tree growth, and I don't expect trees to stop growing anytime soon. Asset manager GMO forecasts that timber will return 6% annually above inflation over the next seven years.
• Tobacco consumption is in long-term decline in advanced industrial nations, but that isn't the case in emerging markets. While Altria is entirely focused on the U.S., its international counterpart Philip Morris International generates nearly half its operating profits from Eastern Europe, the Middle East, Africa, and Asia. Analysts expect long-term earnings growth of just below 10% for the more cosmopolitan company.
• Despite rising awareness of environmental issues, we are still producing huge amounts of garbage, and it will be tough to change that. In the highly concentrated waste disposal and treatment industry, size matters, and the big dog in this business is Waste Management.

Quality stocks are the better option
None of these companies are formal recommendations, but all of them look well positioned to continue increasing earnings and dividends in the foreseeable future. Assuming your investing horizon allows it, now looks like a good time to be buying high-quality dividend stock. Meanwhile, government securities (including zero-coupon STRIPS) may look appealing during periods of market volatility, but their expected returns currently look unattractive relative to other assets under all but the most bearish scenarios.

Not all dividend payers are created equal. Jordan DiPietro has identified the best dividend stock. Period.