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:

*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:

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.