Back to the future: beating bonds by going for equities

In a world where bank deposits provide almost no income, where long-dated bonds offer minuscule income and no inflation protection and where risks to economic growth – and thus to general equities – remain elevated, defensive global consumer franchise stocks continue to represent an attractive investment niche.

It is accepted wisdom in the markets that (in normal times) there is a trade-off between bonds and shares: bonds provide a stable income and a return of your capital, while shares offer potentially higher returns without the guarantee of getting your capital back.

However, this oft-touted insight – while generally correct – is incomplete: we aim to show readers that a portfolio of defensive consumer franchise companies can provide both stable and growing income, and with well below average risk to your capital and upside returns.

As Chart A highlights, at the start of 1994, a US 10-year government bond provided a starting yield of 7.1 per cent or, on a $100,000 investment, an annual income of $7,100, and a guarantee of the $100,000 capital back at maturity.

By the start of 2004, however, long-term US interest rates had declined to about 4.3 per cent. The investor, then, had to reinvest in a new 10-year bond that then provided a lower income of $4,300 annually. Roll forward to early 2014 and when the bond matured again and the same investor – if he/she wanted zero risk – had to reinvest at a yield of 2.3 per cent for an annual income of $2,300.

In other words, for the past 20 years, each time this investor reinvested, he/she had to accept a lower return, and there was never any possibility of growth in the underlying $100,000 investment.

Consumer franchise stocks

Compare this to an investment in early 1994 in eight to 10 US-based global defensive consumer franchise stocks. We define a defensive global consumer franchise stock as being a company with a product (or products) that enjoys stable demand. It is thus defensive in recession, has well-recognised brands which provide a competitive positioning and pricing power, and has strong finances.

These attributes, in turn, allow such companies to grow earnings reliably and consistently over the medium- to long-term. Examples of consumer franchise stocks might include companies such as Coca-Cola, McDonald's, Procter & Gamble, Colgate-Palmolive and Mondelez International.

As Chart A highlights, at the outset in 1994, this basket of stocks was not particularly cheap and provided an initial dividend yield of just 1.9 per cent for a starting income of $1,900 on a similar $100,000 investment.

However, these companies had the ability to grow – and grow they did. Collectively, the basket of US global defensive franchise stocks that we follow grew their dividends by 11 per cent per annum so that today that same investor has a dividend yield of 16 per cent on his/her initial outlay of $100,000.

Equities like this have other benefits too: unlike the income from a bond, an income stream from stocks does not mature, but continues to grow. Moreover, the income return from these stocks is only half the story: the investors also got capital growth. As these companies were paying out, on average, just 50 per cent of their earnings by way of dividends, the remaining 50 per cent were retained to reinvest in new projects and/or acquisitions, and the resultant earnings growth was reflected in higher share prices over time.

The key to using this argument for future investment decision-making is, of course, the reliability one can attach to the dividends and the growth in the dividends from these global giants.

As Chart B demonstrates, this basket of US global consumer franchise stocks has grown earnings at a highly consistent 9 per cent per annum since 1989, compared to 6 per cent per annum for the companies making up the S&P 500 Index.

Moreover, the franchise stocks never had a down year (in aggregate), despite three major recessions over this period. In contrast, earnings from the 500 companies that constitute the S&P 500 Index had three significant dips (1991, 2001-02, 2007-09) over the same period. This superior earnings profile can be attributed largely to these stocks’ superior business attributes.

Putting this together allows us to argue that there is an above-average probability that these stocks are better placed than most companies to continue to grow earnings and dividends at a consistent, reliable pace in the future.

How then might an investor fare in the future? While it is true that dividend payments for this group of stocks grew by an average of 11 per cent compound per annum between 1994 and 2014, this seems like an overly ambitious growth rate.

After all, the global economy is growing at a slower pace today and the problems brought on by the global financial crisis have left developed world consumers more constrained. Hence, we believe that a more modest assumption of 5 per cent earnings and dividend growth per annum is more realistic.

Portfolio

On the same $100,000 investment now, the initial dividend income from the eight to 10 US global consumer franchise stocks is $2,831, for an initial dividend yield of 2.8 per cent. By 2024, assuming 5 per cent annual growth, this dividend income will grow to $4,392. This contrasts favourably with annual interest payments of $2,200 from a similar $100,000 investment in a US 10-year government bond today. And, again, there is no possibility of any growth in the bond income.

While the inevitable rise in long-term interest rates will most likely provide for a better reinvestment opportunity when today's 10-year bond matures in 2024, we would still have a preference for a portfolio of US global consumer franchise stocks and their European equivalents. Darren Gillen is an investment analyst with GillenMarkets.com

* Graphic was corrected on June 10th