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Back to the Future: The Superiority of Equities Over Bonds

Introduction
Here is a startling example of the power of equities over the long-term.

At the start of 1994 (20 years ago), a US 10-year government bond (guaranteed by the US government) provided a starting yield of 7.1%. So, a $100,000 investment in that bond provided the investor with an annual income of $7,100 and a guarantee of the $100,000 capital back at the start of 2004 (when the bond matured).

By 2004, however, long-term US interest rates had declined to circa 4.3%. The investor, then, had to reinvest in a new 10-year bond that now 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 no risk - had to reinvest at a yield of 2.3% for an annual income of $2,300. In other words, for the past twenty 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 capital (the $100,000 investment).

Consumer Franchises Dividend/Interest Income

Compare this to an investment in early 1994 in 8-10 US-based global defensive consumer franchise stocks (detailed in the members' section of the GillenMarkets website).

This basket of stocks was not particularly cheap at the outset in 1994, and provided an initial dividend yield of just 1.9% for an initial income of $1,900 on a similar $100,000 investment. In other words, at the start of 1994, the US 10-year bond looked more attractive with a yield of 7.1%.

But these companies had the ability to grow, and grow they did. Collectively, they grew their dividends by 11% per annum so that today the investor has a dividend yield of 16% on his/her initial outlay of $100,000. The chart above highlights it well.

In addition, this income stream from a collection of companies does not mature. It continues to grow. Moreover, the income return from these stocks was only half the return - the investors also got capital growth in their share prices. The companies were paying out, on average, about 50% of their earnings by way of dividends. So the companies retained the other 50% of their earnings within the company to reinvest in new projects, new products, new distribution lines and/or acquisitions. As the retained earnings also compounded over time, just like the dividends, the share prices of these 8-10 global consumer franchise stocks also grew (delivering capital growth for the investor).

The key to using this argument is, of course, the reliability one can attach to the dividends and growth in the dividends from these global giants. This new Featured Article is aimed at providing you with a clear understanding about why these companies are different than the rest, and why they are a good substitute for bank deposits and longer-dated government bonds.

What Are 'Defensive Global Consumer Franchise Stocks'?
A defensive global consumer franchise stock is a company with strong brands, defensive earnings and competitive positioning which allows it to reliably and consistently grow earnings over the medium- to long-term. Examples of consumer franchise stocks might include companies like Coca-Cola or McDonald's.

The US global consumer franchise stocks have several characteristics that mark them out as defensive growers. Their brands give them above average pricing power, which enables them to pass on cost increases more easily than is possible for most other companies. In addition, they have global reach so that most of them are already benefiting from growth in the emerging markets, which in many cases is compensating for subdued growth in Europe in particular. Finally, the product offerings are defensive - they are everyday low ticket-size items that are either a necessity for everyday life or a luxury you wish not to do without. In other words, demand for their products tends to hold up even when there is a downturn in the economy. So the likelihood of continued earnings growth over the medium-term remains good, in our view.

On our website, we maintain a list of eight US defensive global consumer franchise stocks, along with a list of six European defensive global consumer franchise stocks. That's a diversified basket of fourteen global defensive consumer franchise stocks.

Currently, an investor in this theme can earn a dividend yield of 2.8% from these eight stocks, as compared with 1.9% from US 10-year bonds. Clearly, then, an investor can earn more money from this basket of eight stocks than he or she can from US 10-year bonds.

Can Earnings Grow in the Future?
Is this superior dividend payment achieved only by increasing how much risk an investor is bearing? The risk in this case can be defined as the risk of a decline in dividend payments. And, secondly, can we really rely on the dividend income to grow in the future?

Our answer to the first question is a 'no', and to the second question a 'yes'. We rely on the chart below to provide support for our arguments.

Consumer Franchises Growth in Earnings

The chart shows the earnings growth for our basket of eight US consumer franchise stocks since 1989 - a period of over 25 years. These franchise stocks have grown earnings at a highly consistent 9% per annum, compared to 6% per annum for the companies making up the S&P 500 Index. Moreover, the US consumer franchises never had a down year (in aggregate), despite three major recessions over this time period. The S&P 500, on the other hand, has had at least two significant dips in earnings (2001-02, 2007-08) over the same time period.

Putting this together allows us to argue that there is an above-average probability that the companies in the Global Defensive Consumer Franchise Stocks Theme are better placed than average to continue to grow at a consistent, reliable pace as a result of the competitive positioning, branding, and immense reach of these companies. Moreover, the stability of the earnings stream allows us to argue that there is little risk attached to the future growth of the earnings - and consequently the dividend - stream. 

In turn, then, it is no stretch to argue that dividend payments from this basket of companies will, on average, consistently increase over time as they are backed by reliable, defensive and growing earnings streams.

How Might An Investor in the Theme Fare Today?
Consumer Franchises 5% Growth

Between 1994 and 2014, dividend payments grew by an average of 11.6% compound per annum, which drove dividend payments to be higher than interest payments in just 11 years. Going forward, 11.6% seems like too ambitious a 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 consumers more constrained financially. Hence, we believe that an assumption of 5% earnings and dividend growth per annum is more realistic today.

The chart opposite displays what dividend payments would be in 2024, if we invested $100,000 in the same basket of global franchise stocks at the end of 2014 and assume that the dividend payments grow at 5% per annum. We then compare this dividend stream to the interest payments available from a $100,000 investment in US 10-year bonds, which yielded 2.17% in December 2014.

The initial dividend income from the seven stocks is $2,831, for an initial dividend yield of 2.8% on the $100,000 invested. By 2024, assuming 5% growth, this dividend income would grow to $4,392. This contrasts favourably with annual interest payments of $2,170 from 2015-2024 on a US 10-year Government Bond. And there is no possibility of any growth in the bond income.

Thus, we can see that the investor today who buys into the global consumer franchise stocks receives dividend payments that are higher than interest rates on US 10-year debt along with growth in that dividend over time, unlike the static payments from bonds.

What About Inflation?
While there is little evidence of inflation today, the risk of inflation down the road is above average due to all the money printing at central banks. A 10-year government bond - with a fixed income return - provides no protection against inflation. It is true that if interest rates rise in response to inflation the investor will earn a higher income from a government bond when his/her current bond matures and he/she has to reinvest in a new bond.

But the competitive advantages embedded in the global consumer franchise stocks make it relatively easy for them to raise their selling prices in response to higher costs (inflation). In short, the global consumer franchise stocks have pricing power and can protect themselves, and investors, against inflation.

Accessing the Theme
If you have found this article of value and are interested in the Global Consumer Franchise Stocks Theme, it is very easy to access - one only has to buy all of the stocks in the Theme and hold them for the medium- to long-term. We provide a list of the stocks in both the US and the European Global Consumer Franchise Stocks Theme on our website. In addition, we review the list periodically to see if we can add or remove stocks, and we provide a quarterly update for subscribers on the progress of the Theme over time.

Darren Gillen is an analyst at GillenMarkets.com, the online investment website.