5 Stocks to Beat Bonds

Smart investors don't look at the stock market in isolation. The bond market can teach equity investors some lessons, but I'm starting to feel like Bill Murray's character in the movie Groundhog Day, who kept living the same day over and over:

  • At the start of April, I highlighted the warning signal coming from the junk bond market concerning investors' general complacency. Junk issuance had hit a record in the first quarter.
  • In early May, I reiterated the warning on the basis of the meteoric 88% return from the junk market's low in December 2008, which beat even stocks' huge rally.

Last Thursday, the junk bond market celebrated another "achievement," as average prices rose above 100 cents on the dollar for the first time since June 2007 -- the start of the credit crisis. (Share investors, stay with me; there is an important lesson for you coming up in a little over a paragraph!)

When the ravenous become careless
As the Financial Times writes:

Investors still flock to the [junk] sector because the difference [in yield] between these bonds and low-yielding government bonds remains at historically high levels.

That reasoning is valid for a relative value trade of the sort hedge funds might execute: Junk bonds are cheap relative to government bonds (yield and price are inversely related), therefore buy junk bonds and short government bonds. Unless the investors who flock to junk bonds do the second leg of the trade, they may find that the bonds that were cheap relative to Treasuries aren't cheap at all on a stand-alone basis. The question they should be asking is not, "What is the spread over Treasuries?" but "To what degree do historically high spreads over Treasury yields compensate for historically low Treasury yields?"

Don't fall into this trap!
Stock investors shouldn't throw stones, though, as many of them are falling into the very same trap. I have read numerous commentaries recently where the author concludes that stocks must be cheap because the difference between the earnings yield on stocks (the inverse of the price-to-earnings ratio) and the Treasury bond yield is at historically high levels. As Andrew Smithers, chairman of asset allocation consultancy Smithers & Co., said it to me recently:

It is clearly nonsense to claim to value equities on the basis of bond yields. It assumes that equities are not correctly priced, but that bonds are. Why not point to the yield relationship and say that we have a bond bubble on our hands?

Thankfully, you don't need any half-baked rule of thumb to know there is at least one corner of the stock market that looks undervalued on an absolute basis: the stocks of high-quality, "franchise" businesses. The following table contains five stocks within that category:

Company

Industry

Dividend Yield

P/E Multiple*

ExxonMobil (NYSE: XOM  )

major integrated oil and gas

2.90%

10.6

Home Depot (NYSE: HD  )

home improvement stores

3.16%

15.6

Johnson & Johnson (NYSE: JNJ  )

drug manufacturers -- major

3.51%

13.1

Lockheed Martin (NYSE: LMT  )

aerospace defense products/services

3.61%

9.4

Philip Morris International (NYSE: PM  )

cigarettes

4.64%

14.5

*Based on the price on Sept. 20 and estimated EPS for next fiscal year.

A "high-yield" basket of our own
If we create our own "high-yield" basket with an equal weighting in each stock, this is how it stacks up against the Dow and the S&P 500:

Group

Dividend Yield

Long-term Estimated Earnings Growth

P/E Multiple

"high-yield" basket (equal-weight)

3.6%

10.2%

12.6

Dow Jones Industrial Average

2.7%

9.1%

12.8

S&P 500

2.0%

10.7%

13.3

Our basket has a healthy dividend yield and is competitive in terms of estimated earnings growth and valuation; I think there are pretty good odds it will outperform the indexes over an appropriate time frame (5-10 years, say). However, a basket of five stocks carries much more stock-specific risk than an index fund, so a comparison that relies solely on these numbers is limited.

These two ETFs aren't equally attractive
If you are unwilling to do your due diligence on these stocks, owning the blue-chip SPDR Dow Jones Industrial Average ETF (NYSE: DIA  ) is a superior alternative. However, I can't give the same endorsement to the SPDR S&P 500 ETF (NYSE: SPY  ) . More "democratic" and lacking the same "high-quality" bias as the Dow, the S&P 500 looks to me overpriced on the basis of long-term value measures.

If you're looking for more dividend stock ideas, Matt Koppenheffer will tell you where to find the best dividends.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks in this article. Home Depot is a Motley Fool Inside Value pick. Philip Morris International is a Motley Fool Global Gains choice. Johnson & Johnson is a Motley Fool Income Investor pick. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of ExxonMobil, Johnson & Johnson, and Philip Morris International. Try any of our Foolish newsletter services free for 30 days.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (29)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 22, 2010, at 5:47 PM, vriguy wrote:

    If, like me, you do not have the time and energy to do due diligence and monitoring, why not go with VIG: it holds most of these same high quality franchise names - JNJ, PEP, XOM, KO, CVX, ABT, IBM, MCD, WMT are among the top 10 holdings and has a reasonable expense ratio of 0.23%.

  • Report this Comment On September 22, 2010, at 6:19 PM, TMFAleph1 wrote:

    To avoid any misunderstanding, let me be clear that the title of the article, '5 Stocks to Beat Bonds' is a reference to the fallacious stock valuation model I describe above, which relates stocks' dividend yield to the yield on government securities. Stocks and bonds are not competing assets.

    Alex Dumortier

  • Report this Comment On September 22, 2010, at 6:22 PM, TMFAleph1 wrote:

    vriguy,

    Thanks for your comment with which I agree wholeheartedly: The Vanguard Dividend Appreciation ETF (NYSEArca: VIG) is certainly a good alternative.

    Alex Dumortier

  • Report this Comment On September 22, 2010, at 7:37 PM, goalie37 wrote:

    In my own research, I have been finding some of the best values right now are in high quality, well known large caps.

  • Report this Comment On September 22, 2010, at 7:41 PM, soycapital wrote:

    How about the dividends, with VIG? Do you miss out on the dividends? Do you have to buy 400 shares? Looks like it.

    Thanks for your information.

  • Report this Comment On September 22, 2010, at 7:55 PM, TMFAleph1 wrote:

    @soycapital

    You certainly don't miss out on the dividends with VIG, since it distributes dividend income on a quarterly basis; the current yield is 2.09%.You can see a partial distribution history here:

    http://www.morningstar.com/1/2/270-vig-vanguard-dividend-app...

    As far as the minimum number of shares you need to buy, I'm not sure what 400 represents, but the minimum purchase for the VIG ETF is one share.

    Alex Dumortier

  • Report this Comment On September 22, 2010, at 8:33 PM, TMFHousel wrote:

    "Stocks and bonds are not competing assets."

    I couldn't disagree more with that. It wasn't a coincidence nor was it inefficient that stocks traded at 7 times earnings in the early '80s when bonds yielded 15%.

  • Report this Comment On September 22, 2010, at 9:51 PM, TMFAleph1 wrote:

    "It wasn't a coincidence nor was it inefficient that stocks traded at 7 times earnings in the early '80s when bonds yielded 15%."

    That is a positive description of investor behavior, not a normative one. On this topic, check out this fantastic paper by Cliff Asness which looks at it in some detail. The paper also addresses the conundrum you pointed out in your previous article, "the puzzling fact that stocks out yielded bonds for the first half of the twentieth century and have under yielded bonds for the last 40 years" (per Asness).

    http://investisseurautonome.info/PDF-Downloads/COMMENT-INVES...

    I will admit that there are certain ideas that I am still wrestling with here, but I'm pretty well convinced that the Fed model is bunk on both theoretical and empirical grounds.

    This stuff is fascinating and it really gets to the core of some critical ideas in investing.

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