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W W W. J A N N E Y. C O MMark Luschini, May 2013There are a myriad of ways to determine the return needs of aninvestor. A comprehensive financial plan is probably the bestapproach for individuals and a consultative dialogue leading toan investment policy is likely the best for institutions. In eithercase, the key is to derive an investment goal that realisticallyachieves long-term objectives.While that goal is usually benchmarked to a stock or bondindex, most often in some combination, it may be better formany to consider using purchasing power as an investmentobjective. In other words, the goal should be to grow capitalat a pace that matches or exceeds the cost of living orencumbered liabilities. That is not to disparage the utility ofcapital market indices as a means to evaluate performance, butrather to introduce a more fundamental hurdle most investorsneed to consider when making investment choices.
1W W W. J A N N E Y. C O MInflation Can Erode Purchasing PowerInflation is a silent killer for investors who look totheir portfolio to generate cash flow in supportof meeting expenses. Recent reports of inflationrunning near or below 2% on an annualized basisbelie what investors might actually experience ascosts for shelter, healthcare premiums, tuition, andother items can rise at a much faster rate. Economicconditions over the last several years being subparto historic trends has also contributed to temperinginflation, but a longer term perspective (such asthat provided in Chart A) demonstrates that thisperiod is unusual and higher inflation should beexpected as the norm.Looking at the long-term average of inflationas being north of 3% gives an indication of thehurdle an investor must achieve just to breakeven. If the desire is to grow the portfolio sothat it covers the projected cost of inflation,and generate a positive real return (excessreturn after adjusting for inflation), then targetobjectives of 4% or more are required.In a portfolio construct that is expected to delivera return derived from the yield associated with theinstruments that populate the portfolio, like onecomprised of bonds, CDs or other conventionalfixed-income investments, the income provided—while steady—may not change at all, or at least notrapidly enough to adjust for more sudden changesin prices. This is problematic even at today’s mutedlevel of inflation, let alone in an environmentwhere economic growth accelerates even a bit.Since yields have been deliberately held at lowlevels by the Federal Reserve, traditional sourcesof income, such as government, corporate, andmunicipal bonds, CDs, and money market funds,have been repressed. Thus, investors are facedwith buying those fixed-income securities that insome cases requires one to look to the right of thedecimal point to spot the yield.That condition is unlikely to change anytime soon.Even as the economy continues to show signsof improvement, the Federal Reserve has beenclear in its intention to underwrite its reflationfor a sustained period. In other words, its policyis to maintain very low interest rates until thecommittee members of the Federal Reserve’svoting body determine the economy to be strongenough to withstand higher rates. While thenormalization of the Federal Reserve’s monetarypolicy is inevitable, under the scenario articulatedby Chairman Ben Bernanke, it is not likely thatrates will be altered at all, let alone greatly, forseveral more years.Currently, the yield on the 10-year Treasury bond,considered to be the bellwether against which otherbonds are priced, is approximately 1.7%. At themoment, inflation as captured by the Bureau ofLabor Statistics in a report known as the consumerprice index (CPI measures the prices paid for arepresentative basket of goods and services), isrunning at 1.5% on a year-over-year basis. ThatChart A: Average Annual Inflation by Decade(Source: Janney ISG)121086420–2Percent1913–1919 1920–1929 1930–1939 1940–1949 1950–1959 1960–1969 1970–1979 1980–1989 1990–1999 2000–2009 2010–20125.512.242.537.415.142.942.53 2.353.34Long-TermAverage1913–2012–0.86 –1.9210.10
3W W W. J A N N E Y. C O MInstitutions also face the prospect of matching thedistribution needs over a time horizon measuredin perpetuity, or meeting the obligations of payoutsto retirees that are living longer than ever. Thisplaces a burden on the portfolio architectureto produce attractive returns in a 2% inflationenvironment like today, while anticipating the assetcomposition needed to deliver good results in aclimate of 3–3.5% inflation—the historical annualrate. Adding to that challenge is the same featureof today’s landscape that individual investors face—low bond yields. The 8% return assumptions that acapital markets chart book can illustrate have beengenerated over nearly a century of returns. Theissue, however, is that the “40%” component of thewell-known formula of 60% stocks and 40% bondsfor a “balanced” portfolio, had yields contributingto that return that have historically averaged at amuch higher level than that which exists today.Therefore, that same 8% outcome is more likely tobe achieved only by raising one’s expectation forreturns from the stock portion of the portfolio (sayfrom 10% annually to 12% assuming a 2% returnfrom bonds), or by raising the stock allocation to80% from 60% and assume a trend return. Theadditional stress placed on the portfolio fromassuming a higher-risk profile may generate a levelof volatility, or periods of performance negativelydisparate from benchmarks, that may challenge theinstitution’s practice of policy fidelity.The Purchasing Power SolutionSome investments have a strong reputation forperforming well in an inflationary scenario. Theclassics include commodities, REITs, and stocks.The issue for investors who consider income asan objective is that commodities pay no dividends(unless bought in the form of listed stocks) orinterest income. Publicly traded Real EstateInvestment Trusts, or REITs, are stocks and aretechnically classified to be included in the financialsector of a portfolio. These companies typically ownreal estate in the form of commercial buildings,health care facilities, or apartments to name a few,and can increase rents to account for inflation.Historically, companies have been able to absorbinflating prices as they invest in productivity-enhancing equipment and can pass through coststo customers. While there is a limitation to howhigh inflation can go before it becomes detrimentalto stock prices (historically above 4%), that doesnot appear to be an imminent threat. Therefore,we believe stocks offer a timely but lasting solutionto address the quest for purchasing power.We posit that there are many attractive stocks toown and hold that provide an appealing currentpayout in the form of a dividend distribution,and have demonstrated a history of raising theirdividend. It is that combination—high currentincome that is better than alternative choices,and the ability and track record to provide theshareholder a raise that helps to increase cash flowto match or exceed inflation—that ought to besought by investors. Is it a one-size-fits-all solution?Of course not. Some investors may have the riskbudget to seek capital appreciation at the expenseof volatility and have no need for income; othersmay own bonds as a component of a diversifiedportfolio to stabilize returns and increase thepredictability of longer-term return projections.And yet this “increasing dividend theme” shouldhave wide appeal, given the potential for capitalgrowth from the underlying business accompaniedby the rising stream of income that can be used ascash flow to be spent or reinvested.The S&P 500 index hosts a substantial number ofcompanies whose current dividend yield exceedsthat of the 10- and 30-year Treasury bonds (as of5/1/13). As a rule of thumb, earning a yield froma common stock (predicated upon its dividendpayout) that exceeds what one might earn inthe bond market is a soft hurdle to clear. WhileChart D: Asset Allocation Risk/Return MatrixAssetAllocationAverage Annual Returns PercentPositivePercentNegativeAverageGainAverageLossInflationHedge (1)InflationHedgeStandardDeviation1 year 5 years 15 years 30 years60% Stocks40% Bonds14.7% 5.6% 6.3% 10.8% 75.9% 24.1% 15.3% -7.9% 84.3% 84.3% 13.4%(Source: Janney ISG, Barclays, S&P)
W W W. J A N N E Y. C O M4we encourage that consideration be given tocompanies that may not be included in the indexmaintained by Standard & Poor’s, the fact thatthere are 287 of the 500 with yields in excess of the10-year Treasury bond demonstrates that the poolof candidates is substantial (Chart E).appealing. But even with the higher yield, thatsays nothing about the prospect for appreciationif these businesses grow, or about the richerpayout that might be fielded in time. Thepurchasing power may exist in the current payoutalone, but the real kicker is in the form of thelatter two that offer the potential boost to defendpurchasing power. Consider that these four stockshave had their dividends increase by an averageof 14% year-to-year over the last decade!Perhaps another way to articulate the purchasingpower of a portfolio of dividend-paying stocks isto look at the potential for payout growth. Forexample, if an investor bought $1,000 worthof shares in each of Microsoft, ADP, J&J, andExxonMobil in the beginning of 2003, the dividendyield of that four-stock portfolio would have been1.7%. The dividend payout of that $4,000 portfoliowould have been approximately $67. Fast forward,and that same investor who held onto those sharesbought originally in 2003, would have receivedaround $180 in dividends in 2012. That representsa 4.5% yield on the initial investment. And notonly did the portfolio grow in value from $4,000to $5,700 (price only) by the end of 2012, but thecumulative amount of regular cash dividends overthe course of the decade was $1,181. Long storyshort, the 168% increase in dividend payout in10 years is an example of the purchasing powerthat can be achieved by owning instruments,namely dividend-paying stocks, that can provideshareholders a regular boost in income.Granted, the risk associated with stocks, even AAAones, is greater than that of high-quality bonds orcash equivalents. If, however, we are measuring thetime horizon to evaluate the likelihood of a betteroutcome from this basket of income-producingcompanies that have a precedent for raising theirdividends regularly in five to ten years or more, thenwe would argue the odds tilt favorably toward stocks.Chart F: Dividends Paid Per Share by Calendar YearCompany 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012Microsoft (MSFT) 0.16 0.32 0.32 0.37 0.41 0.46 0.52 0.55 0.68 0.83Automated Data Processing (ADP) 0.50 0.58 0.65 0.79 0.98 1.20 1.33 1.38 1.48 1.62Johnson & Johnson (JNJ) 0.93 1.10 1.28 1.46 1.62 1.80 1.93 2.11 2.25 2.40Exxon Mobil Corp (XOM) 0.98 1.06 1.14 1.28 1.37 1.55 1.66 1.74 1.85 2.18(Source: Janney ISG, Bloomberg)By way of an even more tangible example, considerChart F. There are four AAA-rated companiesin America, assigned as such by Standard &Poor’s, the renowned credit rating agency. Thesecompanies possess several common characteristics,including a fortress balance sheet and a capitalstructure that reinforces the quality of theenterprise. Most, if not all, are household names,but they also are dividend payers. Note in the tablethe dividend payouts of each company over the last10 years—several things stand out. The first is thatthere has been no disruption to that payout, evenduring 2008 when the financial crisis sent the worldinto cardiac arrest and stock prices fell steeply.Also, there was only one occasion where a dividendwasn’t raised from one year to the next—and thatwas Microsoft in the 2004–2005 time period.An even commitment to each position todaywould produce a yield of roughly 2.9%. Comparethat to a 10-year Treasury bond with a yield of1.7%, and inflation of 1.5%, and that seemsChart E: Individual Dividend Yields of S&P 500 Components (5-1-13)(Source: Janney ISG)681012Dividend Yield024DConstituents of the S&P 500 ordered by Yield (lowest to highest)1.63287 of S&P 500 Stocks Yield More than 10-Year Treasury127 of S&P 500 Stocks Yield More than 30-Year Treasury2.83
5W W W. J A N N E Y. C O MGo GlobalThe exercise above was merely intended to bringalive the “increasing income-paying stocks story”in order to demonstrate the way by which one canachieve—and what is meant by—“purchasing power.”Investors do not need to limit their selection processto just four companies. In fact, we believe stronglyin a globally diversified portfolio because the meritsof international investments demand it. Generallyspeaking, incorporating non-U.S. stocks in a portfoliomay enhance results as global equity markets arenot perfectly correlated. This allows investors to spotgreat companies; often times counterparts to a U.S.-based firm that are in similar industries, where thedividend or growth potential is more appealing.In Chart G, we show the yields offered by thestock markets of a sample of developed countries.Obviously, the yields are mostly greater thanthat of the U.S. stock market—the exceptionbeing Japan—demonstrating that the search forthe solution to purchasing power should not beconfined to the selection of U.S. equities because itmay not fully exploit the outcome sought.Concluding ThoughtsPurchasing power is simply the ability to maintaincapital growth that matches or exceeds that ofrising costs. That is a widely adaptable objectivefor individuals and institutions alike. It applies toinvestors in need of current income, and for thosethat seek growth where income is considered acontributing factor to total return.Choices to satisfy the objective of purchasingpower parity mostly do not include governmentand high quality non-government bonds and cash,simply because the yields currently available onthese instruments are close to or are negative ona real basis. Dividend-paying stocks, domestic andforeign, offer the most attractive opportunity setfor building or completing a portfolio designedfor purchasing power. Further scrutiny should beapplied to tease out those companies with sturdycash flows to support the current dividend, as wellas those best poised to increase it.Establishing a portfolio crafted to meet theinvestor’s unique objectives is always paramount,and is what drives the asset allocation decision. Thisprocess should involve fashioning a solution thatmaintains purchasing power today, as well as intothe future—a goal common to virtually all investors.Chart G: Foreign Stock Yield(Source: Janney ISG, Bloomberg)543210PercentUnited States Australia France UK Germany Switzerland Canada JapanInternational investments currently hold particularappeal because of valuation disparity whencompared with the U.S. There is also an academiccase whereby holding both U.S. and internationalstocks in combination helps to optimize a portfoliobecause of the different correlations betweencountries, currencies, and risks associated withvarious markets. The literature tends to be shapeddepending upon the time period in review, butit consistently respects a notion that promotesinternational diversity.