September 2021 Client Letter

Thanks to a modest monetary gift from my grandfather, I began investing in the early 1990s. Given that my dad was editor of the monthly investment newsletter, Richard C. Young’s Intelligence Report, investment advice was never in short supply. One individual my dad began featuring in his letter during the 1990s was Jack Bogle, founder of The Vanguard Group. Back then, Bogle was new to the scene as far as the general investing public was concerned. But at 2 Training Station Road in Newport, RI, where I grew up, he had already become a household name.

What attracted my dad to Bogle was how he brought simplicity to a complex industry. And he did so with integrity. In a forward to an edition of Bogle’s first book, my dad wrote, “I have given copies of Bogle on Mutual Funds to both my son and daughter, who base their own mutual fund investing on the principles outlined in Jack’s book. It is the first reference source I recommend to anyone who is seriously investing for the future.”

My frame of reference for investing began nearly 30 years ago with the obvious help from my dad and an emphasis on the principles outlined by Jack Bogle. Much of the early wisdom I gained from Bogle has been an invaluable guide. One of the first tenets I learned from him was to think long-term. Bogle wrote, “Do not let transitory changes in stock prices alter your investment program. There is a lot of noise in the daily volatility of the stock market, which too often is ’a take told by an idiot, full of sound and fury, signifying nothing.’ Stocks may remain overvalued, or undervalued, for years. Patience and consistency are valuable assets for the intelligent investor. The best rule is: stay the course.”

Emotionally Challenged

Now I know that staying the course and thinking long term are no longer novel investing concepts. And yet we still find individuals unable to practice these basic principles. A whole field of study is dedicated to these emotionally challenged investors; “behavioral finance” studies the effects of psychology on investors and financial markets. It focuses on explaining why investors often appear to lack self-control, act against their own best interest, and make decisions based on personal biases instead of facts. And it’s one of the reasons that individuals seek out professional guidance.

Several weeks ago, I read an interview in Barron’s. The gentleman interviewee was a respected 70-year-old economist and professor from Boston, MA. He understands personal financial planning, taxes, finance, and health care.

Barron’s asked how he was invested with his own money. He responded:

It seems to me that the stock market is overvalued and dependent on the Federal Reserve’s support and its commitment to low-interest rates. And I view that as an unsupportable policy, so I view the stock market as very risky. About half my assets are in cash because I think this is a very tricky investment climate.

I pulled out of the market when Covid hit, and the market dropped, and I was very proud of myself. But I didn’t expect the Fed would come back in and support the corporate bond market to the extent it did.

For clarification, Barron’s asked if he missed the boat on the market rebound.

I missed out on the rebound, staying out of the market for about half a year.

Ouch. Missing out on six months of the Covid recovery hurts. It’s nearly impossible to get those gains back. And while he said he is proud of himself for getting out of the market during COVID, I suspect he may have taken some initial losses. This demonstrates the impact that volatility and negative headlines can have on an individual, including a seasoned investment professional.

Volatility and steep stock-market declines often lead to the type of emotionally charged investment decisions that sabotage portfolio performance. I have referenced Dalbar’s data many times before in these monthly letters, and this time, the message is stark. For the 30-year period ending in 2016, the average investor underperformed the stock market by a staggering 6.18%, and the bond market by an equally disturbing 5.77%. Investors buy at the wrong time and sell at the wrong time. Volatility and emotion are often contributors here.

The best course of action, as Jack Bogle encouraged, is to stay the course when markets become volatile. An important element to staying the course is having a portfolio that adequately reflects your risk tolerance, your time horizon, and your past experiences during difficult times.

The Wall Street Journal’s Jason Zweig nicely summarized past experiences.

Try recalling how frightened you felt as an investor in February and March 2020. … No matter what you think now, you were terrified then. Everybody was. But the epic recovery from the Covid crash of early 2020 has reinforced the sense that markets are safer now. … That’s made it all but impossible for most of us to reconstruct how afraid we were only a year-and-a-half ago. We see the past through a rearview mirror made of rose-colored glass. Brushing aside our losses creates a false bravado that makes us think we can weather the future with less fear than we suffered in the past.

While risk can never be eliminated from an investment portfolio, proper diversification can help cushion the blow of big stock-market declines. That can allow retired investors and those approaching retirement to avoid hitting the panic button.

I often find that once investors own a quality, diversified, and balanced portfolio, volatility is viewed in a different light.

Sleep Well at Night

Another strategy for helping you to ride out volatility and sleep well at night is owning the more boring and stodgier parts of the market. The boring and stodgy, by definition, are not going to provide the flashy appeal and hype of names like GameStop, Tesla, and Bitcoin. But flashy appeal can come with a price in the form of higher valuations, inconsistent track records, and a sole reliance on capital appreciation as opposed to capital appreciation and consistent, annual dividend payments.

We mostly focus on boring and stodgy stocks, which tend to be big blue-chip companies that are dominant within their industry. They can provide predictable sales and profit growth throughout the business cycle. Usually, they are financially stable with healthy balance sheets.

During August, we placed several trades in a number of portfolios that can be described as boring and stodgy. Those stocks included Northwest Natural Holding, Conagra Brands, and Reynolds Consumer.

All three are typical of the companies we tend to target. We lean toward companies with a track record of annual dividend increases or ones where we feel confident about future annual dividend increases.

Northwest Natural Holding Company, through its subsidiaries, builds and maintains natural gas distribution systems and invests in natural gas pipeline projects. Northwest Natural Holding serves residential, commercial, and industrial customers in the United States and Canada. Northwest Natural Gas shares yield 3.57%. The company has paid a dividend every year since 1952, and they have increased the dividend each year for 65 consecutive years.

Conagra Brands, Inc. manufactures and markets packaged foods for retail consumers, restaurants, and institutions. The company offers meals, entrées, condiments, sides, snacks, specialty potatoes, milled grain ingredients, dehydrated vegetables and seasonings, and blends and flavors. Conagra shares yield 3.65%, and we are looking for double-digit dividend growth over the medium term.

Reynolds Consumer owns the Reynolds Wrap brand, which markets aluminum foil, parchment paper, plastic wrap, and oven bags. Reynolds also owns Hefty brand trash bags, plates, and cups. Reynolds trades at a reasonable valuation and offers a relatively attractive dividend yield of 3.20% today. We anticipate dividend growth of 5%–7% over the medium term.

The Three Ds: Dividend Yield, Dividend
Growth, and Dividend Growth Consistency

Most of our equity purchases need to meet certain criteria to be added to our portfolio. Three of those criteria include a dividend, a history of dividend growth, and a decent dividend growth rate. Limiting purchases to companies that pay and increase dividends tend to keep us out of the more speculative, high-flying areas of the market.

The technology sector is one where the power of paying dividends to shareholders is not well appreciated by management teams and corporate boards. As a result, technology stocks are a sector we tend to eschew. We feel this is not a problem in the long run, as this sector runs the highest risk of catastrophic loss (“a loss of 70% from peak value with minimal recovery”) among the 11 sectors in the S&P 500.

We do own some technology businesses, but we see them as more similar to industrial businesses. The technology stocks we purchase are most often more established and mature businesses with cash flow profiles that support regular dividend payments and regular dividend increases.

Three such tech stocks we own for many clients are Analog Devices, Texas Instruments, and Automatic Data Processing.

Analog Devices and Texas Instruments are both in the analog chip business. Analog chips are used to convert analog or real-world signals such as sound, temperature, and pressure into digital signals that can be processed. In our view, the analog chip business has attractive economics. Analog chips are relatively cheap for buyers, many of them are embedded in products, and their manufacturing processes aren’t overly complicated, so the risk of a customer switching to a different provider is low.

Texas Instruments (TI) is the world’s largest analog chipmaker and a key supplier of embedded chips. The company’s chips serve a wide range of industries. In 2020, 37% of TI’s revenue was from the industrial sector, 27% from personal electronics, 20% from the auto sector, and the balance from communications equipment and enterprise systems. TI shares offer a yield of 2.3%, the company has increased its dividend for 17 consecutive years, and, over the last decade, the dividend growth rate has averaged almost 22.5%.

Analog Devices is a leader in analog, mixed-signal, and digital-signal processing chips. Like TI, Analog serves a diversified mix of industries, including industrial companies, communications firms, automotive firms, and consumer businesses. Analog’s dividend has been increased every year for the past 17 years. Over the last decade, the dividend has grown at a compounded annual rate of more than 11%. The shares yield 1.56% today, and we are forecasting continued double-digit dividend growth in the near term.

Automatic Data Processing (ADP) is not in the chip business. It is one of the largest payroll and tax-filing processors in the world, serving over 920,000 clients and paying more than 38 million workers in approximately 140 countries and territories. If you have worked for a large company in the United States, there is a strong possibility your paycheck was processed by ADP. ADP shares yield 1.84% today. ADP has increased its dividend for 45 consecutive years and, over the last decade, the dividend has increased at a compounded annual rate of more than 10%.

Equal Weight vs. Market Cap

When we craft investment portfolios, we size positions in a fashion that contrasts with the typical weighting scheme of broad-based market indices. Ours is more or less an equal-weight approach. The S&P 500 (probably the most popular broad-based market index) weights positions by market value, so the biggest companies count much more toward the performance of the index than the smallest companies. In fact, Apple’s weight in the S&P 500 is greater than the combined weight of the smallest 150 companies in the index. Put another way, Apple is almost 400 times more important to the performance of the S&P 500 than the smallest company in the index.

Market-cap-weighted indices may give the illusion of diversification, but the truth is investors are effectively making a bet on a handful of stocks in similar sectors. Information technology stocks (like Apple) and Communications Services stocks (that include Facebook and Google) make up 39% of the S&P 500. The top six stocks in the S&P 500 account for a quarter of the index.
The energy sector, which includes companies that make the fuel to run our cars, power our homes and businesses, and transport goods and services across continents and oceans, accounts for 2.5% of the S&P 500.

Market-capitalization weighting works fine when the handful of the largest businesses and sectors that dominate the index are performing well, but such a strategy could be extremely problematic during a market downturn.

In our opinion, something closer to equal weighting provides more robust diversification than market-value weighting.

Fixed Income

We recently sold a position in long Boeing bonds that were owned by many clients. We purchased the bonds early in the pandemic. They had a maturity of 20 years, longer than we typically favor, but they also had an attractive coupon that we did not feel was commensurate with the risk of a Boeing default. The market eventually agreed with our opinion, and the bond price rose significantly from our purchase price. We decided to sell the position because the yield advantage the bonds offered had normalized, leaving the bonds more susceptible to both interest-rate risk and a resurgence in credit risk. A further decline in interest rates could theoretically lead to higher prices for the bonds; but we think lower interest rates will more likely come from renewed Covid restrictions. A clear negative for Boeing. The proceeds from the sale of Boeing bonds have been earmarked for more bond purchases.

In the current fixed-income environment, investing in bonds has been challenging. Ultra-low interest rates on Treasury securities are holding down interest rates on corporate bonds. While corporates offer better yields than Treasuries, they are still low by historical standards. Our approach for the current environment has been to be highly selective and hold an elevated cash position. We aren’t wild about holding cash, but cash brings down the maturity profile and interest-rate risk of a bond portfolio, and it provides optionality for a sudden change in circumstances. You can think of a high cash balance as a Treasury position in normal times. Coming into Covid, we held a significant portion of fixed-income portfolios in Treasuries. That didn’t look like a great idea until the corporate bond market started to fall apart in February and March. Having dry powder in the form of Treasuries allowed us to take advantage of the dislocation in corporate bond markets and scoop up bonds like the Boeing issue we just sold.

Have a good month. As always, please call us at (800) 843-7273 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Hard work, patience, and compounding. If you are looking to pass some financial wisdom down to your kids or grandkids, here is something worthwhile you can share. The maximum amount workers can contribute to their 401(k) for 2021 is $19,500. And if you are under the age of 50, you can contribute $6,000 to an IRA. If someone makes max contributions to both, they could save $25,500 annually. Assuming an average annual return of 7% and allowing 35 years of compounding, these contributions will grow to roughly $3.8 million.

P.P.S. As I have written in the past, we often have investment strategy discussions with the adult children of current clients. Some clients reached out, asking if there is flexibility with our new account minimums. The answer to this question is yes. If you have children or other family members you believe would benefit from our investment counsel, please encourage them to give us a call or send an email. We are happy to help.

P.P.P.S. Have you met your 2021 required minimum distribution (RMD)? Do you plan on making a charitable donation from your IRA in 2021? To help us facilitate the processing of your RMD by year-end, we recommend you submit a completed distribution form before December 1. If you haven’t satisfied your RMD and don’t have a distribution plan in place, please contact our office as soon as possible. Submitting your request early will allow us to address any problems before year-end. If you fail to take your RMD by the December 31 deadline, a 50% penalty may be assessed on the amount you are required to take.

P.P.P.P.S. Each year, Barron’s ranks the nation’s top independent advisors. Richard C. Young & Co., Ltd. has been recognized on this list for 10 consecutive years.

* Rankings published by magazines, and others, generally base their selections exclusively on information prepared and/or submitted by the recognized advisor. Rankings are generally limited to participating advisors and should not be construed as a current or past endorsement of Richard C. Young & Co., Ltd. Barron’s is a trademark of Dow Jones & Company, Inc. All rights reserved.

June 2021 Client Letter

As things look today, it appears we may head into summer facing more troubling financial headlines than we saw during the first half of this year. Inflation has been a big topic this past month, but now headlines regarding volatility are becoming more prevalent.

While I was writing this month’s letter, a visit to the Barron’s homepage included the following headlines: 

• The Dow Just Had Its Worst Week Since October. Why It Could Get Worse.
• Investors: Prepare for a Volatile Summer.
• Interest in Buying Stocks Is Fading. Check Out the Numbers.

All three headlines are, of course, meant to grab your attention, but basing investment decisions on headlines designed to sell subscriptions is not the best strategy.

After a big bull-run like the one markets experienced over the last year, it is natural to feel unease about the prospect of a correction. Who wants to see the value of their portfolio fall from a high? I often remind clients feeling anxious about a potential correction that markets move in two directions.

The S&P 500 was up nearly 12% in the first four months of the year. If stocks continued to climb at that rate for the balance of 2021, the S&P 500 would be up 40% for the year. While stocks have gained 40% in a single year, the last time it happened was 1954—over six decades ago. The more likely scenario is that stocks won’t be up 40% for the year, which implies a correction in price or at least a lull in the pace of gains.

Despite what financial headlines want investors to believe, the fact that markets periodically experience declines does not necessarily warrant concern or panic.

Headlines Don’t Predict the Direction of Stocks

Headlines, after all, are often poor predictors of the direction of stocks. Remember this one from The Atlantic in 2016? “Donald Trump’s Economic Plans Would Destroy the U.S. Economy”. The author writes, “Trump has promised to make America great again. But a closer look at his policy proposals, such as they are, suggests that within his first few years as president, he would more likely make America recessionary again.”

And it wasn’t just journalists who got it so wrong. Even Nobel-Prize-winning economist Paul Krugman said Donald Trump would bring global recession.

Clearly, no recession was caused by Trump’s election or the policies he put in place.  Contrary to what The Atlantic and Paul Krugman predicted, the economy and markets boomed, and unemployment fell to the lowest level in decades.

We heard similar catastrophic predictions about what would happen to the United Kingdom if they went through with Brexit.

Foreign Policy ran with a headline in 2018 that said, “A No Deal Brexit Will Destroy the British Economy.”

How is the U.K. doing post-Brexit? The excerpt below is from a recent article in The Telegraph that provides a nice summary.

Rewind five years, to the morning after a vote that took almost everyone by surprise, and the consensus was that the British had committed economic suicide. The pound dropped by the most on record, at one point getting close to parity with the euro and even the dollar. Investors fled from the London market. A new Prime Minister was desperately searching around for some kind of strategy for leaving the EU, and business was attempting to work out how it could cope with our departure. As we now know, the predictions of Project Fear turned out to be wildly overblown. House prices haven’t collapsed, unemployment hasn’t soared, and although some jobs have been lost, factories have not relocated wholesale to France and Spain, nor has the City decamped en masse for Frankfurt and Paris even if Amsterdam has picked up some trading business.

Reading the headlines and the news is a necessary part of managing an investment portfolio, but it’s important to remember that headlines are written to sell newspapers and subscriptions, and news is best used to inform rather than to advise.

Inflation Headlines

As mentioned above, the dominant theme in today’s financial headlines seems to be the prospect for faster inflation. Measured by the Consumer Price Index (CPI), inflation is 5% today. Inflation of 5% or more has been rare over recent decades. The chart below shows the annual rate of inflation for the CPI since year-end 1989. There were a couple of months in 2008 when oil spiked that inflation rose above 5%; and then in the early 1990s, inflation was over 5% for a few months.

If inflation persists at 5%, it would indeed be a problem for financial markets. Long-term interest rates would likely increase significantly, driving down the price of most assets, including stocks, bonds, and real estate.

Soaring money supply and rising commodity prices do not help put investors’ minds at ease about the prospect of higher inflation. What should offer some comfort is that bond investors with actual money on the line expect inflation in the medium term to average 2% to 2.25%.

Inflation May Be Temporary

For now, we are waiting to see if the higher pace of today’s price increases is temporary or lasting. Low CPI readings from last year, when oil briefly dipped into negative territory,  along with pent-up demand and supply-chain constraints caused both by COVID-19 (COVID) and a sudden shift in spending from services to goods appears to be the primary driver of today’s elevated readings. As the economy works through these supply and demand issues, we are likely to get a better read on how much of today’s elevated readings are temporary versus permanent.

If investors begin to believe inflation has gotten ahead of the Fed, we should brace for a potentially difficult period in markets.

What should you do in the meantime?

Two Investment Tactics for Inflation

Number one, be invested. One of the biggest mistakes individual investors make is not being invested. Retirement is expensive, especially when factoring in the constant effects of inflation—whether that inflation is moderate or otherwise. Your dollars will only keep up with inflation if given a chance. They have no chance sitting in your bank account.

Number two is to include assets in your portfolio that can help hedge against inflation. Real assets such as commodities or gold can hedge against inflation, but over the long run, so do stocks. We especially like dividend stocks for this purpose.

Companies that make regular annual dividend increases that exceed the rate of inflation are effectively providing you with an inflation-adjusted income stream.

In our view, on a risk/reward basis, dividend-paying stocks make a lot of sense.  Many of the companies we own are ones we consider to be blue-chip, and they possess the characteristics to ride out the business cycle. Dividend payers also tend to provide the most comfort and peace of mind during difficult stock market environments, given their relatively reliable income streams.

Our goal is to buy companies we believe will hold their value for the long term. We are not buying based on what we expect will happen next month or next quarter. And we do not sell just because an industry or a particular company goes through a tough period.

We’ve held energy stocks and pharmacy stocks for years now. Both have experienced difficult environments, but for now, it appears as though they’ve turned a corner. Energy shares tumbled in 2014 when oil prices crashed from over $100 to less than $30. They fell further following COVID when the world locked down and oil demand cratered. Today, oil is trading back above $70 per barrel, and oil and gas shares have recovered.

Pharmacy stocks struggled in recent years partly due to investor fear that Amazon was entering the business. Slow foot traffic, in addition to some pricing pressure in other parts of the pharmacy business, has kept share prices of CVS and Walgreens at deeply depressed levels; but both stocks are now rallying as consumers return, and the Amazon threat hasn’t yet materialized in any meaningful way.

With Six Months Down, How Are We Doing?

I don’t tend to get too caught up in the performance of a portfolio over shorter time frames. I have clients I’ve worked with for over 20 years, and analyzing returns over months and quarters is not always relevant.

But, to provide perspective and outlook for the rest of the year, I will review how our three main asset classes have done so far in 2021.

Retirement Compounders

The Retirement Compounders (RCs) is our globally diversified portfolio of dividend- and income-paying securities. Most RCs securities are individual stocks, including Caterpillar, Evercore, Hershey, Intel, and Visa. We are at the halfway mark of the year, and most of you, as of this writing, have received all your dividends as expected and are also benefiting from dividend increases. In addition, the RCs as a group have had healthy returns YTD.

Reasons for the gains include lots of money in the system, 0% interest, and the reopening of the global economy, among other factors. Also, year-over-year (YoY) comparisons of corporate earnings have been positive. Given that these factors should remain in place for the rest of the year, it’s reasonable to assume that the stock market may have more juice left in the tank in 2021.

But, as mentioned above, we still need to get a better feel for the inflation outlook. Currently, it appears that the market thinks the Fed has inflation under control. If this outlook changes and the narrative switches to one in which inflation has gotten out ahead of the Fed, markets could get bumpy.

Bonds

Last year caused lots of disruptions in the financial markets. When the COVID crisis began, we braced for yields to collapse across the board. Fortunately, this was not entirely the case within corporate bonds. Reasonably attractive yields remained for a period of time. Yields ended up declining during the rest of 2020, which pushed up the value of our bonds. From a return standpoint, the bonds did extremely well last year—double- and upper single digits for most portfolios.

But the strong returns came with a price: near-historic low yields today. Cash and short-term paper are essentially offered at 0%. And, somehow, we live in a world where U.S. GDP growth for 2021 is projected to be 6.5%. And there are inflation concerns, yet the 10-year Treasury note yields just 1.5%. GameStop and AMC sure do hog a lot of print in the media, but I think the yield on the 10-year Treasury note is the story of the year. Investors, especially those in or nearing retirement, could really benefit from higher interest rates.

Portfolio Insurance

Gold has bounced around this year. Gold declined during the first three months, recovered in April and May, and is now again in negative territory. But this is not a complete surprise. Gold tends to perform well during periods of stress, unrest, and uncertainty. Last year we had all three: COVID, closure of the global economy, riots in the U.S., and an election. When you stir that all together, you get a big heap of uncertainty, which creates an ideal environment for the shiny metal. If you want to know why we own gold in your portfolio, 2020 is your answer. Compared to last year, 2021 is a breeze. There is much less uncertainty, and the global economy is making significant progress. Gold tends to be desired less in these types of benign environments.

Have a good month. As always, please call us at (800) 843-7273 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Did you know that the U.S. accounts for only about 25% of global economic output? Investors who eschew international stocks may be forgoing most of the world’s economic and investment opportunities. Investing internationally can also better diversify your portfolio. Global economies and markets don’t always move together. When the U.S. zigs, Switzerland may zag. What’s more is that after years of U.S. outperformance, foreign markets may be overdue for a period of catch-up. Over the last decade, the U.S. has outperformed foreign markets; but in the prior decade, it was foreign markets that bested the U.S.

P.P.S. We started purchasing the Fidelity Floating Rate fund in client portfolios last spring when COVID fear was wreaking havoc in financial markets. This fund invests in bank loans. While we tend to favor individual securities in most of our investing, loans are not easily traded and held by individual investors. The only practical way for most investors to gain exposure to loans is via a mutual fund or ETF. Here’s Kiplinger’s nice explanation of the Fidelity Floating Rate fund:

As interest rates fell in 2019 and 2020, investors paid bank loans little attention. But an economic recovery and the likelihood of rising short-term interest rates are prime conditions for these loans, which pay an interest rate that adjusts every few months in step with a short-term [sic] bond benchmark. When yields rise, most bond prices fall. But bank loans, often called floating-rate loans, retain their value. The managers at FIDELITY FLOATING RATE HIGH INCOME, Eric Mollenhauer and Kevin Nielsen perform detailed analysis on each company before they add a bank loan to the fund. Bank loans are typically issued to firms that have junk credit ratings (double-B to triple-C). That means they have a higher risk of default, so Mollenhauer and Nielsen are right to be choosy. Along with 20 analysts, each an industry specialist, the managers build a diversified portfolio one loan at a time based on a company’s prospects over the next two to three years. Floating Rate High Income has a reputation for being more conservative than its peers, tilting toward firms rated double-B, the highest-quality end of high-yield credit ratings. That’s still true, but lately, the fund holds more of its assets than usual in loans rated single-B. These days, it’s a risk worth taking. “With an accommodative Federal Reserve, pent-up demand, and the potential for a big infrastructure package, our companies are set up well,” says Nielsen. The fund yields 3.03% today.

May 2021 Client Letter

When I started working at Richard C. Young & Co. Ltd., our sole investment focus was investing in U.S. Treasury securities. The most profitable strategy we implemented during the early years of the 1990s was long-term zero-coupon bonds. The zeros strategy was classic. Unlike Treasury bills or intermediate-term notes, long-term zero-coupon bonds can significantly appreciate when interest rates decline. And, since zeros are backed by the U.S. government, they are free of default risk.

In running the zeros strategy, our daily research centered on the momentum of the U.S. economy, the Fed, and the direction of interest rates. In the years before spreadsheets, the web, and the cloud, various market and economic data points would be recorded daily into notebooks. As I write, I have one of my first notebooks in front of me. It is hard to believe the numbers I recorded. By example, in September 1993, a three-month certificate of deposit (CD) offered you 2.60%. A 10-year full-faith-and-credit-pledge U.S. Treasury note paid you 5.36%. Yields remained at those levels and even higher for several more years. What a great time to begin retirement!

Today, we are unfortunately a long way from the yield environment of the 1990s. The 10-year Treasury closed at a record-low 0.52% last August. The yield has climbed back up, but at 1.63% it remains historically low.

The broad stock-market also doesn’t offer much in the way of yield these days. The yield on the S&P 500 is currently 1.48%, and the NASDAQ offers a paltry 0.78%.

The chart below shows the evolution of the yield on a 50-50 portfolio of stocks and bonds, as measured by the S&P 500 and the 5-year Treasury rate, respectively.

To state the obvious, the environment for investors seeking income is much more hostile than it was in the early 1990s when full-faith-and-credit-pledge Treasuries offered 5%-plus.

An Income Plan

As investors continue to evaluate their investment strategy, I believe a greater emphasis will need to be placed on income generation. While the income environment has been bad for quite some time, it has been somewhat overshadowed as stock prices have been rising. An environment where stock returns are modest or negative will certainly cast a harsher light on today’s ultra-low yield environment. When constructing future investment portfolios, investors will need to take a harder look as to where their portfolio income will come from.

The Retirement Compounders® Solution

Fortunately for you, we have always emphasized yield. Low dividend-yields and appalling valuations during the dotcom bubble were the catalysts for establishing our Retirement Compounders® program (RCs). RCs is our globally diversified portfolio of dividend- and income-paying securities. When valuations are high (as they are today), stock-price appreciation can stall and remain depressed for long periods. By example, it took the S&P 500 more than 13 years to meaningfully surpass the high it had reached in March of 2000. It took the lower-yielding NASDAQ composite 16 years to achieve the same feat.

The compounded annual total return of the S&P 500 from March 2000 to March 2013 was 2.27%. Over the same period, the Bloomberg Barclay’s T-bill Index earned 2.25% annually. In March 2000, the RCs didn’t exist, but the NASDAQ Dividend Achievers Select and S&P Dividend Aristocrats indices did. Both pursue similar dividend-focused strategies to our Retirement Compounders®. Dividend Achievers compounded at 5.5% and Dividend Aristocrats compounded at over 9% during the same 13-year period. Dividends and dividend growth helped boost the total return of both indices relative to the S&P 500.

A Yield 65% Higher than Inflation

Today, the RCs portfolios we are crafting for clients offer yields of approximately 3.0% or 65% more than the rate of inflation. What’s more, when inflation rises, firms’ profits and dividends also tend to increase.

Financial Stocks

Today we see financial stocks offering attractive yield opportunities. And with the economy poised for significant growth, loan and investment quality will likely remain solid.
Financial stocks we purchased over the last year include Evercore, US Bancorp, and Washington Trust.

Evercore

Evercore is the world’s leading independent merger-and-acquisition (M&A) investment advisory firm based on transaction value. The firm’s investment banking business generated 98% of its revenues in 2020 via fees from advisory clients. Evercore’s advisory services reach beyond just M&As and include:

• a strategic shareholder advisory service through which Evercore advises on activist shareholders, shareholder communications, and defense strategies;
• special committee assignments through which Evercore advises special committees with impartial, unconflicted advice; and
• transaction structuring through which Evercore advises on corporate events such as spin-offs, sales, joint ventures, and more.

Other Evercore operations include a capital markets advisory, an institutional equities arm, and other smaller businesses. Over the last ten years, Evercore’s board has increased its dividend per share by 15.95% annually, and the company can boast about 16 dividend increases in a row.

U.S. Bancorp

U.S. Bancorp is a holding company that owns U.S. Banking National Association, an American-based bank selling corporate and commercial banking, consumer and business banking, and wealth management and investment services to its clients. The company’s roots go back to 1863 when Abraham Lincoln signed a national bank charter spawning the First National Bank of Cincinnati with a mission to “Pursue a straightforward, upright banking business.” Another U.S. Bancorp predecessor, Mississippi Valley Trust Company, even helped Charles Lindbergh finance his transatlantic flight in 1929. Today, U.S. Bancorp subsidiary banks reach 26 states with 2,730 branch offices and 4,406 ATMs and are the fifth-largest commercial bank in the United States by asset size. U.S. Bancorp has paid a dividend every year since 1963. The shares yield 2.77% today.

Washington Trust Bancorp Inc. is the holding company of The Washington Trust Company, the largest state-chartered bank headquartered in Rhode Island. The Washington Trust Company, a premier regional financial services company in the northeast, was founded in 1800. It’s the oldest community bank in the United States. Today the bank runs 23 branches, five wealth management offices, seven residential mortgage loan offices, and three commercial lending offices. The bank sells commercial banking; mortgage and personal banking; wealth management; and trust services. Washington Trust Bancorp has increased its dividend for ten consecutive years. Growth over this ten-year period has averaged 9.3% per year. Today, shares can be purchased with a yield of 4.00%.

Investing in Bonds is a Strategy, Not a Trade

As difficult as it is to earn a decent yield in the stock market, the bond market is even more challenging today. However, that doesn’t mean bonds should be left out of your portfolio in favor of more stocks, as some advisors contend.

Investing in bonds is a strategy, not a trade. Bonds give you the courage to stick with stocks during down markets, and bonds help moderate the ups and downs of your portfolio. Just because bonds don’t offer attractive yields at this moment doesn’t mean they don’t offer benefits to investors, and it doesn’t mean they won’t ever again offer attractive yields.

While bonds still belong in most investors’ portfolios, navigating the bond market when interest rates are in the tank is not a set-it-and-forget-it affair. When interest rates were much higher, investors could park some cash in T-bills or short-term Treasury notes and earn 3% to 5% without taking default risk. That compensated for inflation and offered a decent return.

Today, T-bills are being issued with a yield of 0.00%, and short-term Treasury notes offer yields in the range of 0.30%. There is still no default risk, but that safety will cost you money after factoring in inflation.

A Tactical and Opportunistic Approach to Bonds 

To deal with this period of ultra-low interest rates, we have taken a tactical and opportunistic approach with bonds. As the prior economic cycle was maturing, we scaled back the credit risk in our clients’ bond portfolios and scaled up Treasury positions. Going into the COVID crash, we held a significant position in Treasury bonds that we sold as interest rates on corporate bonds shot up. Remember, higher yields equal lower bond prices and vice versa.

Many of the corporate bond positions we purchased with the proceeds of Treasury sales worked out well for our clients.

As the economic implications of the pandemic came into focus, and the Fed made it clear it planned to hold short-term interest rates at zero for years, we moderately increased the average maturity of our clients’ bond portfolios to boost yield.

Late last fall, with corporate bond prices back to normal levels, the vaccine news, and a spendthrift administration coming to power, we sold some of our longest-maturity corporate-bond positions and purchased high-yield bonds and bank loans. Both have much higher credit risk than investment-grade bonds; but, with a supportive monetary and fiscal policy and an improving economy, we saw the risk-reward tradeoff as appealing.

As we moved into 2021 and interest rates started to climb, we have slowly and deliberately drawn on our elevated cash position to purchase higher-yielding bonds. We have purposefully held cash at elevated levels in recent quarters. Cash is not an exciting investment, but cash has outperformed bonds YTD. And cash offers optionality, which we view as highly desirable in the current environment.

These tactical moves, which may sometimes seem counterintuitive, are part of a strategy for navigating the ultra-low-interest-rate environment. I would like nothing more than to be able to buy long zeros as we did in the early 1990s at exceptional interest rates, but that’s simply not the environment we are in today. Our environment is one where, since March of 2009, T-bill yields have averaged about 0.50%, and short-term investment-grade bond yields have averaged about 1.5%. By taking a tactical and opportunistic approach, we have been able to improve on these numbers.

In Front of the Action

One of the best ways to handle a stock-market correction is to be properly positioned ahead of significant volatility. During the last two major crises, the Financial Crisis and COVID-19, we did not take specific action during the initial stages of the market correction. Most of our clients already owned diversified portfolios that included a significant allocation to bonds and gold. This helped limit the stock market’s downside volatility. Having proper asset allocation based on risk tolerance is one of the best defenses to deal with a bear market.

Have a good month. As always, please call us at (800) 843-7273 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Diversification vs. concentration. Some professional investors eschew diversification. This crowd tends to subscribe to the philosophy that you should carefully pick the best eggs and watch them closely. But how many best eggs (ideas) can one have? The problem we see with this approach is that today’s best idea may turn out to be tomorrow’s biggest loser. That isn’t a problem specific to concentrated portfolios. There is often a disaster or two in every portfolio (even the ones we manage!). The trouble is, you don’t know which are the disasters ahead of time, and in a concentrated portfolio, a single wipeout can result in financial heartache. Consider that, just before the turn of the century, a concentrated stock manager may have considered Enron, Bear Stearns, Lehman Brothers, General Motors, and GE to be his best-ideas portfolio. All were Fortune 500 companies at the time; but, looking back, four went bankrupt and the fifth has lost almost 80% of its value. Proper diversification is essential to earning a return of capital and a return on capital. At Richard C. Young & Co., Ltd., we craft portfolios focused on cash flow. We diversify geographically and across industries, sectors, and asset classes in an effort to achieve the return of capital and a return on capital.

P.P.S. I get asked about inflation often. One way to deal with inflation risk is to invest in companies that can pass price increases along to the consumer. Demand for toilet paper, diapers, and toothpaste, by example, is unlikely to fall much as their prices increase. We own positions in Procter & Gamble, Kimberly-Clark, and Colgate in many client portfolios.

P.P.P.S. We recently updated both Part 2A and Part 2B of our Form ADV as part of our annual filing with the SEC. This document provides information about the qualifications and business practices of Richard C. Young & Co., Ltd. If you would like a free copy of the updated document, please contact us at (401) 849-2137 or email cstack@younginvestments.com. Since the document was last updated in March 2020 there have been no material changes.

P.P.P.P.S. After trailing the market badly in 2020, energy is having a banner year. The S&P 500 energy sector is up 40%, the highest return among the 11 sectors in the index. Oil-and-gas demand is returning to normal, while supply may take longer to return as capital spending plans were curtailed last year. Despite their strong performance YTD, the oil-and-gas majors, as well as refiners and pipelines, remain an attractive source of dividend income. Chevron, a holding in many client portfolios, recently announced a 3.8% dividend hike. Chevron shares yield 4.9% today.

March 2021 Client Letter

Staying invested during extreme market downturns may seem counterintuitive when losses are piling up, but it is often one of the best decisions an investor can make. That doesn’t mean portfolio positioning and individual holdings should be set on autopilot. During the height of the pandemic and lockdowns, we were constantly reviewing portfolio holdings. The abrupt onset of COVID-19 and the government reaction to it, which was the real black swan in our view, created significant uncertainty. While we had concerns with some portfolio holdings, we were confident in the resiliency of the group of securities we held for you.

Why the confidence in the face of such great uncertainty? I would cite three reasons.

Diversification

Crafting a resilient portfolio is more than just deciding which stocks and bonds to buy and sell. In our view, proper diversification between asset classes, among sectors, and among individual positions is the key to crafting a portfolio that can offer comfort and confidence in uncertain times.

Cash Flow is King

Owning securities that pay a stream of income can also give you the confidence to ride out the tough times. The payment of income can cushion the blow of falling prices. And getting a regular dividend check in difficult economic environments indicates that the company you are investing in has confidence in its own business and the cash flow to pay it. We buy stocks and bonds expecting that their dividend and interest payments can be maintained through an entire economic cycle. It doesn’t always work out that way and, admittedly, lockdowns and social distancing weren’t much of a consideration when many of the stocks and bonds we own for clients were purchased. During the height of COVID-19 uncertainty last spring, we had concerns about which companies might have to suspend dividend payments; but we can count on one hand the number of stocks that actually did so.

Experience

I have been speaking to investors for nearly 30 years about the market and its impact on their life savings. One thing I have observed over this period is the importance of staying invested. When you start playing the game of getting out of the market because of some variation of “this has never happened before,” you greatly increase the risk of missing the rebound.

An old Wall Street adage says market tops are a process, and market bottoms are an event. Investors who want to catch a bottom have to invest at the point of maximum pessimism (and uncertainty). That’s a lot easier said than done in the heat of battle.

You can see in the chart below that the bull markets that started on March 9, 2009, and March 23, 2020, held to the pattern of an event. In the first 60 days (horizontal axis is days before and after bear market bottom) of both bull markets, the S&P 500 was up over 30%. It is unlikely many investors who sold in March of 2020 because of the uncertainty of COVID-19 would have had enough confidence to buy back in by the end of May.

Being on the sidelines during these rallies can be detrimental to the long-term value of your portfolio. The chart below from Fidelity compares the growth of $10,000 in the S&P 500 from 1980 through 2018. Investors who owned stocks for the entire period saw their $10,000 investment turn into $659,515. Those who missed the 10 best days saw less than half of the gains, and those who missed the best 50 days saw about a tenth of the gains.

Remember: We are an investment counsel firm that invests your money, not a trading counsel firm that trades your money. Investing is a long-term endeavor that presupposes busts as well as booms. It is not always easy to keep your composure during a bust, but selling after a big decline is one of the worst mistakes a long-term investor can make.

Why Bonds Still Make Sense

One way we help clients avoid that mistake is by investing in bonds. With today’s interest rates at ultra-low levels, I am sometimes asked, “What is the point of owning bonds?” It’s a good question.

In our view, bonds are more than a source of income—though they do provide income. Perhaps more importantly, bonds act as ballast for your portfolio. Bonds give you the courage to own stocks, especially in down markets.

The Necessity of Owning Bonds

This is especially true for retired investors who no longer have the luxury of dependable wage income. For retired investors relying primarily on their portfolio to fund living expenses, bonds are necessary.

You will understand why bonds are necessary when you consider the poor hypothetical investor who bought $1,000,000 worth of an S&P 500 fund at year-end 1999 with plans to take a 4% inflation-adjusted annual draw through retirement. A nasty 3-year bear market that took the index down 49% from peak to trough followed. By the end of 2002, this investor’s portfolio would have been worth approximately $523,000. To maintain his purchasing power for his 2003 distribution, he would have been looking to take $42,000, or 8%, of his remaining wealth.

Talk about an ulcer-inducing way to begin retirement. And if this hypothetical investor is like many investors, he would have thrown in the towel and bought bonds after it was too late. Assume our hypothetical investor switched to a 50-50 portfolio at year-end 2002. The chances of running out of money over a 25-year retirement with an 8% withdrawal rate invested 50% in stocks and 50% in bonds may be as high as 91%.

Market Euphoria Reminiscent of Dot-Com Bubble

What is interesting about this example is that there are many similarities between today’s market and the market that preceded the dot-com bust. Take the number of bubble stocks (our definition) as an example.

What are bubble stocks? We define them as stocks that have increased more than 500% over the last year. Why 500% over a year? It is arbitrary, but it is a nice round number that is so high it would be difficult to explain as something justified by improving fundamentals (there are rare exceptions).

The chart below plots the number of bubble stocks by quarter. The last time we saw anything close to this kind of mania was during the dot-com bubble. Seasoned investors have the benefit of knowing how this type of mania often ends.

The good news is that bubble conditions in the market are not pervasive. The market is extremely bifurcated in terms of value. Some stocks appear to be priced at irrationally exuberant levels, but pockets of relative value can still be found.

We see pockets of value in the dividend-paying names we tend to favor. We also see better relative value internationally.

Home Bias 

What comes to mind when you think of the stock market? For many Americans, the stock market means the Dow or the S&P 500. There is nothing wrong with that, but U.S. stocks are just one part of a much larger global equity market. There are 6X as many investable foreign stocks as there are U.S. stocks.

Investors around the world tend to think about markets in terms of their home country. Economists call this “home bias.” Home bias is rooted in the familiar. People are more comfortable with what is familiar to them, and that bias holds for their investing activities.

The problem with home bias is that it can result in a situation where assets become too heavily concentrated in one area. There are benefits to investing globally because U.S. and foreign stocks don’t tend to move in unison. Periods of volatility and performance don’t always sync up between domestic and foreign markets.

U.S. vs. International Market Leadership

Charles Schwab recently pointed out that market leadership between U.S. and international stocks tends to last for many years before reversing. It tends to switch at the start of a new cycle. The table below from Schwab indicates that, during the 1980s, international stocks led U.S. stocks by an annualized 6.2%. The decade of the 1990s went to the U.S. The dot-com bubble helped U.S. stocks outperform by 8.8% during the 1990s. In the 2000s, leadership flipped back to foreign stocks; but since December of 2007, U.S. stocks have held the leadership role. What will the 2020s bring?

Currencies and International Investing

Currency fluctuations play a meaningful role in the performance of international stocks. When an investor owns stock in a foreign company, the value of that stock not only depends on the company’s performance but also on fluctuations in the exchange rate between the investor’s home currency and that of the company.

U.S. investors in international stocks may experience a gain in their investment’s value when the dollar weakens as the strengthening currency of the underlying security bolsters it. Australia’s performance during the 2000s offers an instructive example. From year-end 1999 through year-end 2007, the MSCI Australia Index was up 208%, but U.S. investors who purchased an ETF tracking Australia’s market would have earned 312% over this period as the U.S. dollar also fell against the Australian dollar. Currency fluctuations cut both ways. From year-end 2009 through year-end 2016, the dollar index rose 33%, dragging down the performance of international stocks in U.S.-dollar terms.

At Richard C. Young & Co., Ltd., we take a global approach to portfolio management. We invest in foreign stocks and, when the opportunity is right, foreign bonds. Today, approximately a quarter of the equities we hold for clients are invested internationally. Your allocation to international stocks may differ from that figure depending on when you started with us and which international stocks we currently favor.

The foreign stocks we buy for clients tend to have characteristics similar to the U.S. stocks we buy. We favor dividend-paying stocks with records of making dividend increases. Dividend-paying conventions internationally tend to be more focused on payout ratios as opposed to dividend levels. We put less weight on consecutive dividend increases with international stocks.

Today, we are favoring Swiss stocks for international exposure. In a world of negative interest rates and what seems like non-stop liquidity injections from global central banks, the Swiss franc could act as a haven if inflation and currency debasement take hold in countries more focused on monetary intervention.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer 

P.S. In February, we purchased additional positions in the iShares Broad High Yield Corporate Bond ETF. With another $1.9 trillion in stimulus likely on the way, on top of the $900 billion passed in December and vaccines rolling out at a pretty good clip, the near-term outlook for the economy is solid, in our view. There is even talk that the size of the stimulus may overheat the economy. That points to a lower risk of corporate defaults and higher Treasury rates. High-yield bonds are likely to perform stronger in relative terms than Treasuries in such an environment. The iShares ETF was purchased at a yield of 4.04%.

P.P.S. I also wanted to comment on your cash position. We recognize the elevated amount of cash in your portfolio. Most of this is earmarked for additional bond purchases. It is worth pointing out that since the end of July of last year, the Bloomberg Barclays US Aggregate Bond Index is down 3.2%, and the Bloomberg Barclays US Corporate Bond Index is down 2.84%. The long Treasury bond is up 1.08 percentage points in yield, and the 10-year Treasury yield is up 1.0 percentage points over this period. While cash yields nothing, the low yields in the broader fixed-income market mean the opportunity cost of holding cash is lower than normal, and the option value of having cash is greater than normal. We will be looking to invest this money, but we don’t want to force the money into bonds on unappealing terms simply to bring down your cash position.

P.P.P.S. “Electric is real. The stock prices of companies in the space are not,” said Erik Gordon, an assistant professor at the University of Michigan’s Ross School of Business. “The dot-com boom produced some real companies, but most of the overpriced dot-com companies were lousy investments. The electric boom will be the same story. Some great companies will be built, but most of the investors who chase insanely-priced companies will be crying.”

P.P.P.P.S. Is oil headed back toward $100 per barrel? With all the focus on green and renewable energy, one might think that the oil and gas business is finished. It’s possible that demand will peak within the next couple of decades, but don’t forget that supply and demand set the price. Every year without additional investment, the world’s oil supply falls by millions of barrels a day. Oil demand collapsed in 2020, but so did investment. That will limit supply in the near-to-medium term.

Quoting from a recent FT article, “We’re going to be short of oil before we don’t need it in the years to come,” JPMorgan’s head of oil and gas, Christyan Malek, told clients on a conference call last week. “We could see oil overshoot towards, or even above, $100 a barrel.”

Oil and gas shares are also a good sector to own should inflation become a problem. And oil and gas stocks offer some of the most attractive dividend yields in the stock market. The top four energy stocks we hold in client portfolios offer an average yield of 5.4%.

December 2020 Client Letter

America’s pension fund managers face some difficult choices. With bond yields near record lows and pension liabilities rising, pension managers have to choose between taking more risk or asking for employers and employees to make greater contributions.

Low prospective bond returns are not the only challenge pension fund managers face. As explained in a recent Wall Street Journal article, Wilshire Consulting, an adviser to large pension funds, recently lowered its 10-year annual return projection for stocks to 5.5%. The firm’s 10-year projection for bonds fell to 1.75% from 3.25%.

Lower Your Return Expectations

If Wilshire is right, investors in a 50-50 portfolio should expect no more than a 3.63% return over the next decade. That’s a far cry from the 7.2% return assumed by the median U.S. public pension plan. In Canada, pension fund managers assume something closer to 5.6%. If the 25 largest U.S. funds used that same 5.6%-return assumption, their assets would fall about $1.5 trillion short of the value of their liabilities.

How will pension funds make up the shortfall? The prudent option would be to increase contributions, but when greater contributions require tax hikes, the decision is not so simple. Faced with the apparently untenable option of asking plan sponsors to hike taxes, some pension plans are trying to boost returns by investing in assets that allow managers to assume higher future returns because past performance has been strong. Think private equity and venture capital. Other managers have taken the unusual step of using leverage to try to boost returns.

Prudent Man Missing at Pension Funds

It is difficult to rationalize the thought process. It wasn’t that long ago that stocks were viewed as inappropriate investments in pension plans. In 1962, only about 5% of pension fund assets were invested in stocks. And even in 1982, only about a quarter of pension fund assets were invested in equities. Today, thanks to the Fed’s decision to decimate interest income, pension fund managers are using borrowed money to leverage stocks in an effort to boost returns.

Leveraging pension assets to boost returns is against the advice of the Government Finance Officers Association. The strategy of borrowing money to boost returns is also not permitted in your IRA account.

What Do Pension Funds Have to Do with You and Your Portfolio?

What do pension fund problems have to do with you and your portfolio? We are all investing in the same public markets. Individuals, pensions, and other investors are faced with the same prospective returns offered in the public markets.

And while individual investors might not chase returns by borrowing on margin or investing in private-equity funds, some are looking in the rearview mirror and chasing growth stocks in an attempt to reach for return.

After all, if today’s low-prospective return environment presents a challenge, doesn’t it just make sense to invest in growth shares? Investing in growth certainly sounds like a better way to earn a return.

Who doesn’t want growth in their stocks? And why? Plus, haven’t growth stocks beaten the market by a lot over recent years?

Value-Oriented Strategies the Long-term Winner

Indeed, the latter point is undoubtedly true; but, unintuitively, over the long run, value-oriented stocks have performed best.

The chart below shows the long-term performance of $100 invested in high-dividend-yield stocks (value-oriented) versus $100 invested in growth stocks. The data comes from the Kenneth French Data Library. High-dividend stocks are measured by the top 30% of stocks ranked by yield and weighted by market value. Growth stocks are measured as the top 30% of stocks ranked by price to book (the most common metric to distinguish growth from value) and also weighted by market value.

As you can see in the chart, high-dividend stocks are the clear winner. Over the long run, it’s not even close. One hundred dollars invested in high-dividend stocks in June of 1927 is worth almost $1.5 million today. That same $100 invested in growth stocks is worth about $530,000 today.

The reason value-oriented shares outperformed growth shares is not because growth shares don’t have greater growth—they do. Value’s outperformance comes from a rebalancing effect. By example, you might buy a stock when the dividend yield is far above the market and sell that stock at a later date when the yield is far below the market. The same thing happens with growth stocks. A growth stock selling at a high price-to-book value may see growth slow, pushing it out of growth stock territory and resulting in growth funds selling the shares at a lower price.

According to Rob Arnott, chair of Research Affiliates and former editor of the Financial Analyst’s Journal, from 1963 through 2007 this rebalancing effect added 5.4% annually to value strategies and detracted 7% annually from growth strategies. The net effect was a 12.4% advantage for value shares. Since 2007, these figures are about the same. So even though growth stocks have greater growth in their fundamentals than value stocks, that growth differential isn’t enough to overcome the drag that growth strategies suffer from because of the rebalancing effect.

But if value-oriented strategies have a structural advantage over growth strategies, why have value shares lagged over recent years? Value-oriented strategies have had their longest period of relative underperformance on record, punctuated by their worst relative-performance year on record this year (through October).

Growth’s strong relative performance can be attributed entirely to investors’ willingness to pay what seems like an ever-increasing price for the same dollar of sales, earnings, dividends, or book value. The chart below shows the price-to-sales ratio of the Russell 1000 Growth index. The recent spike rivals what was seen in growth stocks during the dotcom bubble.

Growth Stock Bubble

Does this mean growth shares and growth strategies are in a bubble? Probably. Jeremy Grantham’s G.M.O., an authority on bubbles, believes growth stocks have entered a bubble similar to the one in 2000. Whether it’s the speculative activity in blank-check companies and other IPOs, the massive rallies in bankrupt companies, or the performance of clean energy and electric vehicle (E.V.) stocks like Tesla, the mania is obvious.

G.M.O. summed up the mania in E.V. stocks in their third-quarter letter to investors.

Tesla has risen some 800% since the fall of 2019 on the back of 17% growth in vehicles sold. It now has a greater market cap than the sum of all the other U.S. automakers, all the European automakers, and all the Korean automakers, with Honda, Mazda, and Nissan thrown in for good measure. That collection of companies sold approximately 100 times as many cars as Tesla did in 2019. But Tesla isn’t the craziest thing that happened this year, and that is true even if we restrict ourselves to looking only at the electric vehicle companies named after Nikola Tesla. This spring a would-be Tesla called Nikola went public via a reverse merger with a SPAC at a valuation of $3 billion. In the 2020 E.V. frenzy, it rose 10-fold to a market cap of about $30 billion. This company is a rare bird in the stock market, a pre-revenue manufacturing company. In fact, Nikola is not only pre-revenue, having never sold any vehicles it has produced, it has never produced a vehicle. Further, it has not even built the factory in which it aspires to build the trucks that it has yet to sell….

With a combination of some of the highest valuations ever seen and clear corresponding manic investor behavior, it seems clear to us that growth stocks are indeed in a bubble.

As was the case during the dotcom bubble, the mania has left behind value-oriented shares. The price-to-sales ratio for the Russell 1000 Value Index is somewhat elevated based on the depressed level of sales, but nowhere near the extreme levels seen in growth shares. 

While Wilshire Associates is right to lower its return projection for the broader market, the sectors and strategies of the market that have lagged more recently may offer better relative long-term opportunities moving forward.

We would include dividend stocks in that camp. This past year was not a great one for dividend investing. But it could have been much worse. Back in March, three of our main investment-related concerns included how long the economy would be closed, the 10-year Treasury yield dropping to 0.54%, and how company dividends would be impacted.

While we had reasonable confidence you would continue to receive the expected cash flow from your equities, there was no way to be sure early on. You will be pleased to know that most stocks in your portfolio did not suspend or cut their payouts this year. There were a couple of notable exceptions, including Cracker Barrell and Texas Roadhouse. Being forced to close up shop made dividend cuts the prudent decision for these businesses.

Some of the companies we own for many of you increased their dividends in 2020. Despite a challenging and uncertain environment, Home Depot, Chevron, Air Products, Evercore, Union Pacific, and Sika all paid greater dividends in 2020 than they did in 2019.

Home Depot

At Home Depot, they say the company is “built from all the right materials.” It’s a clever way to describe a home improvement goods store; but it also sums up Home Depot’s core value structure that relies on creating shareholder value, entrepreneurialism, taking care of employees, excellent customer service, respect for all people, doing the right thing, building strong relationships, and giving back. Home Depot began implementing that vision back in June of 1979 when it opened two warehouse stores in Atlanta, Georgia, that stocked 25,000 products, a number that dwarfed the competition. Today, Home Depot operates over 2,200 stores in the United States and Canada, each averaging 105,000 square feet in size. This year, Home Depot was added to the Mergent Handbook of Dividend Achievers after raising its dividend for each of the last 10 years. With an eye towards its core tenet of creating shareholder value, Home Depot increased dividend payments at an average annual rate of 19.71% for the last decade. Shares yield 2.22% today.

Chevron

Chevron is one of the world’s largest publicly traded oil companies. The worldwide economic slowdown has taken a toll on many oil producers by decreasing demand for energy across the board, but Chevron has maintained its AA credit rating and has the lowest net debt of any of its peers. Chevron operates at the lowest “dividend breakeven” price of oil. That means while other oil majors need to dip into savings to pay dividends while oil is selling below, say, $60 per barrel, Chevron can maintain its cash at a mere $50 per barrel of oil. Crude oil prices are above $50 per barrel today. Chevron shares have a yield of 5.98%, and the company has raised its dividend each year for the last 32 years straight.

Air Products

If you’ve ever eaten frozen pizza, you probably weren’t thinking about the nitrogen used to cool the pizza before it was boxed, but maybe next time you will. Much of the nitrogen used to freeze pizza and many other foods is supplied by Air Products. In fact, Air Products supplies gases that enable over 30 industries to do business. Using machines like MRIs, welders, cryogenic freezers, fire suppression equipment, oil fracking rigs, and more demand the specialized gases Air Products provides. Air Products has been in business for eight decades and has increased its dividend each consecutive year for the last 37. Over the last five years, the dividend has compounded at 10.1% per year. Today, Air Products’ shares yield 2.02%.

Evercore

Evercore is an independent investment bank that derives the majority of its revenue from financial advisory services, including merger, acquisition, and restructuring advisory. Evercore has consistently gained market share. The company’s shares took a hard hit during the pandemic as investors responded to the temporary plunge in mergers and acquisitions (M&A) activity. The M&A market has come back to life, along with Evercore’s shares. Evercore has raised its dividend every year for the last 13 years. Over the last five years, the dividend has increased at a 15.4% annual rate. The shares yield 2.25% today.

Union Pacific

This year, as they track their online purchases, many people are learning a lot more about logistics and transportation than they ever wanted to. You may even be tracking your Christmas packages across America as I write, wondering if that special gift will make it in time. The backbone of America’s goods transportation system is the railroad system, and one of America’s largest railroad companies is Union Pacific. That’s the same Union Pacific tasked by Abraham Lincoln to build part of the original transcontinental railroad. Since its days connecting the two coasts of America, Union Pacific has grown to 32,236 route miles, linking most of the western half of the United States in an intricate web of railroad tracks. Union Pacific has increased its dividend each year for the last 13 years, at a whopping rate of 21.22% on average over the last ten. Shares of UNP yield 1.91% today.

Sika

Sika is a Swiss-based building products company. Its products are used primarily for bonding and sealing. The firm produces additives for concrete, sealants for roofing and flooring, waterproofing systems, and light-weighted components for the automotive and wind-generation industries. Innovation is one of Sika’s key strategic pillars. Sika has 800 unique patent families with over 3,400 single national patents. The company’s shares offer exposure to our favored Swiss franc. Sika pays a modest dividend; but over the last five years, Sika has increased its dividend at an almost 14% annual rate.

Confidence and Comfort

Home Depot, Chevron, and Union Pacific are blue-chip household names, whereas Air Products, Sika, and Evercore are not as widely known. We view these lesser-known companies in the same high regard as the more familiar names. Owning a combination of blue-chip household names as well as off-the-beaten-path names helps to diversify your portfolio.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Treasuries and GNMA securities were once a large component of the fixed-income portfolios we manage for clients. With Treasuries yielding less than 0.50% all the way out to a five-year maturity and GNMA securities yielding less than 1%, our current focus has shifted to individual corporate bonds with a small emphasis on floating-rate loans and high-yield bonds.

P.P.S. The U.S. Congress just passed a $900-billion stimulus bill. This was a scaled-down version of the first bill. After dumping trillions into the economy in the spring, the $900-billion stimulus seems like a small additional step. The left views this stimulus as a down payment; but following the 2009 financial crisis, the U.S. stimulus was $787 billion. Lulled into complacency by low central-bank-manipulated interest rates, America has become numb to the scale of debt and deficits. But rising government debt levels risk igniting inflation once the economy fully recovers. You can already see it in the housing market (not included in the Consumer Price Index). What is the best hedge against the risk of rising inflation? TIPS (Treasury inflation-protected securities) should be your go-to option in most scenarios; but with inflation-adjusted yields of -1%, TIPS are a non-starter today. To hedge inflation in the portfolios we manage for you, we own gold and precious metals, diversify globally, and favor companies with pricing power and the ability to make regular dividend increases.

November 2020 Client Letter

One of the costliest investment mistakes you can make is overreacting to current events and political or economic instabilities.

You may know someone who exited their equity positions in March or April, consumed with COVID-19 fear. On the surface, you can appreciate the initial reasoning: a deadly virus with no cure in sight was infecting individuals around the globe. In response, governments shut down economies until further notice. How can companies survive without commerce?

Instead of panicking and selling, I counseled many of you about the additional inputs we considered that gave us the confidence to stay the course: the U.S. economy entered the crisis on solid ground; past civilizations have survived viruses; we have a sophisticated, modern health-care system; many sectors of the economy would remain open for business, and consumers were still flush with cash.

 At Richard C. Young & Co., Ltd., we included all those inputs and more into our reasoning for not selling stocks. Additionally, we had confidence in our portfolio of companies and their ability to weather the storm and continue to honor their dividend commitments. Keeping a level head in the midst of panic is often the best strategy.

We did not, however, sit on our hands during the past eight months. In our view, portfolio adjustments were required. By example, we added to our gold position in March. We did not view this as a speculative trade. Given the elevated global uncertainty, the amount of government stimulus, and the Fed cutting rates to zero, we thought this to be a prudent trade. Our bond portfolios also required fine-tuning. Yields on government bonds hit rock-bottom, with the 10-year Treasury yielding 0.58% on April 21. As a result, we liquidated all our Treasury holdings, redeploying them for higher-yielding and higher-returning opportunities in the corporate bond market.

The month of October and the first days of November tested investors’ resolve once again. Instead of the virus, many were concerned with the looming election. Reading through poll results and listening to the media gave some investors concern that a “blue wave” would give single-party control of government to Democrats. As of this writing, either divided or single-party governments are still possible. The markets often favor divided governments as there is less momentum for major policy changes, potentially reducing uncertainty.

Regardless of your election-outcome prediction, making significant portfolio changes immediately before an event with an unknown outcome is often not the best way to manage your investments. Ideally, your portfolio is allocated in a manner reflecting your goals, risk tolerance, and time horizon. Once you consider these factors, a plan can be put in place. Then, moving forward, the changes made are more about fine-tuning than drastic action and disruption. 

Unfortunately, many investors look at big events as a signal they should take portfolio action. But this is not an ideal, long-term strategy. Vanguard Group founder Jack Bogle said, “Don’t do something, just stand there!” Bogle also added, “We encourage investors to trade about $32 trillion a year. So the way I calculate it, 99% of what we do in this industry is people trading with one another, with a gain only to the middleman. It’s a waste of resources.”

Our View of the Landscape Post-Election

With the election behind us and the outcome not as bad as feared (pending the two Georgia Senate races), we see an economy continuing to progress. One of the brightest sectors of the economy is housing. Low-interest rates and a new wave of home-buyers have ignited a boom in the housing market.

Existing home sales are at their highest level in 15 years. New home sales are showing similar strength, and the National Association of Home Builders Sentiment Index is at a record high. Housing activity is a major part of the U.S. economy, and it has a strong multiplier effect on other parts of the economy.

Homebuyers rarely just buy a house. Along with a new home comes new furniture, paint jobs, remodeling, new appliances, and improvements to the landscaping. Many parts of the economy benefit when the housing market is strong.

The consumer side of the economy also looks healthy despite a lapse in fiscal stimulus. Consumers have plenty of savings from earlier stimulus efforts. And once immunization against COVID becomes widespread, pent-up demand will be unleashed for services that have been restricted.

Bond-Market Strategy

How does the economic landscape shape our view of the bond market? With economic data holding up so far in the fourth quarter along with positive vaccine news, we expect the recovery to continue. We do anticipate a flattening of growth as the Biden administration’s regulatory efforts weigh on business sentiment, but it may not be enough to cause an economic contraction. Divided government, assuming at least one Georgia Senate seat is won by the Republicans, is likely to restrain additional deficit spending. And once the COVID crisis has passed, we would expect Republicans to clamp down on further spending. This should restrain inflation from what it otherwise might be under a blue-wave scenario.

Our base case, with an admittedly still-cloudy policy picture, is moderate economic growth and moderate inflation. In a moderate growth and inflation economy, we see some risk to longer-term yields. The 30-year Treasury bond currently yields 1.60%, which is lower than during the financial crisis. It would not be unreasonable to see long-term Treasury rates move back up to 2.5% or more as the economy recovers and inflation moves off today’s deeply depressed levels.

For some clients, we own bonds with maturities close to 30 years that we purchased in the spring at deeply discounted prices. One of those was a Lowe’s issue due in 2047, which has since been sold. We bought the Lowe’s bond at an extremely wide yield advantage (spread) to Treasuries. Wide spreads can provide a cushion from rising Treasury yields. With the spread on the Lowe’s bond moving back toward more normalized levels, it is now more susceptible to rising long-term interest rates. As a result, we sold. There are a handful of other issues with maturities similar to the Lowe’s bond that we are likely to sell as their yield advantage to Treasuries normalizes.

Paring Back Gold and Silver

We have also pared back our exposure to gold and silver. For a host of reasons, including a continued economic recovery, a likely divided Congress, an election outcome that points toward a rejection of the most liberal part of the Democratic party, and the risk that longer-term rates move higher, we are more neutral on gold and silver today.

We reduced gold and silver mostly in tax-deferred portfolios but also in portfolios where the weightings rose to levels that demanded action. We will likely make additional sales of gold and silver after the first of the year to avoid realizing additional taxable capital gains in 2020.

With the proceeds of the longer-term bonds and precious metals, we are increasing exposure to lower-grade bonds. That means high-yield bonds and floating-rate loans.

We believe high-yield and floating-rate fixed-income securities offer a relatively attractive way to add yield to portfolios. The current environment appears to be favorable for both where we have an improving economy and a Fed policy that supports corporate credit, and in which any additional fiscal stimulus efforts are likely to be focused on the most impacted areas of the economy. The latter tend to be sectors with more lower-rated bond issues.

Fidelity Floating Rate

The Fidelity Floating Rate Fund invests in bank loans of issuers rated below investment grade. Bank loans are senior debt in the capital structure of a company. In the event of default and liquidation, bank loan investors get paid before unsecured bondholders, preferred equity owners, and common shareholders.

Bank loans are floating-rate securities. Loan holders receive a spread above the rate on short-term interest rates. By example, a loan may pay SOFR (the replacement for LIBOR) plus 4%. When the SOFR rate rises, so do interest payments to loan holders. 

Bank loans are best accessed by individual investors via a fund. There is lots of paperwork generated between each trade, and trade sizes are far outside the scope of what an individual can do while maintaining diversification.

The Fidelity Floating Rate Fund is our preferred vehicle for investing in bank loans. The fund has an SEC yield of 4.08% with a duration of essentially zero because of the floating rate nature of the loans. 

Investing in High-Yield

In the high-yield space, we are investing in both a high-yield bond ETF and individual high-yield bonds. The high-yield bond ETF provides access to some issues that we cannot purchase on an individual basis. The fund is also easier to enter and exit than open-end, high-yield mutual funds that sometimes have minimum holding periods and redemption fees. High-yield bonds are not an asset class we favor as a permanent part of a portfolio. Liquidity and ease of entry and exit are essential. We tend to favor high-yield bonds during the early stages of the credit and economic cycles.

The high-yield ETF we favor today is the iShares Broad US High Yield ETF (USHY). USHY tracks the Bank of America High Yield Index, which is the old Merrill Lynch High Yield index. The fund has an expense ratio of 0.15% and an SEC yield of 4.70%. 

Risks to Watch Today 

In terms of identifiable risks in the near term, we would point to the outcome of the Georgia Senate elections. If Democrats win both Georgia seats, personal and corporate taxes are likely to increase significantly, and government will have a bigger role in the economy (bad for growth).

A failure of the various vaccines in development to meet safety or efficacy standards could also derail the economy. Case counts, hospitalizations, and deaths have prompted governors to institute additional restrictions that impede economic activity. The stock market is currently looking through these measures to sunnier days in anticipation of a successful vaccine. Should the vaccine disappoint, we could see a reversal of recent equity gains.

A significant rise in long-term interest rates could also be a problem for the market. Stock prices are baking in a long period of ultra-low long-term interest rates. Should long-term interest rates rise meaningfully, we could see a correction in stock prices.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Part of our ongoing analysis on your behalf is determining the future reliability of a company’s dividend. Some have asked about the sustainability of AT&T’s dividend, given how high it is and how much debt the company owes. We remain confident AT&T has the capacity to continue paying its dividend. We tend to look at the statement of cash flows to judge dividend strength along with future business prospects and the balance sheet. Over the last year, AT&T has generated close to $30 billion in free-cash-flow. The dividend eats up about half of the free-cash-flow. In other words, AT&T’s free-cash-flow could theoretically fall by half, and the company would still be able to meet dividend payments. And while AT&T has taken on a lot of debt in recent years to make acquisitions, the company’s current cash flow supports the debt load. Low-interest rates are also helping AT&T’s cause. These factors are not a guarantee the dividend won’t be cut, of course, but a good indication it doesn’t have to be cut.

P.P.S. Price declines and volatility have made energy stocks a difficult sector to own in recent years. We view energy on a long-term basis, though. The energy stocks we own offer some of the best yields in our portfolios. Refiners Valero and Phillips 66 offer yields of 6.8% and 5.4%, respectively. Chevron’s dividend yield is 5.50%. Fifteen years ago, the energy sector made up 10% of the S&P 500, and the information technology sector made up 15% of the index. Today, energy accounts for 2.5% of the S&P 500, and technology (broadly defined) makes up 38%. The last time we saw such a wide divergence was March of 2000. Our seasoned clients know what happened over the subsequent decade. For the benefit of those who may not recall, from March 31 of 2000 through the next ten years, the S&P 500 energy index compounded at 9.35% while the S&P 500 technology index lost 7.98% on an average annual basis. Past performance is, of course, not a predictor of future performance.  

P.P.P.S. I am pleased to announce that Richard C. Young & Co., Ltd. was named in the Top 10 of CNBC’s 2020 Top 100 Financial Advisors ranking. For the second year in a row, we are one of only a handful of firms with listed offices in Florida or Rhode Island to make the list.

P.P.P.P.S. Our equity strategy concentrates on blue-chip stocks with a history of paying dividends. A focus on quality companies paying out cold, hard cash each year can be comforting during periods of uncertainty. But annual dividends are not the whole story. We also target companies that raise their dividend each year. Annual dividend increases are critical in helping offset the nasty effects of inflation—one of the most significant risks investors face.

As we head into 2021, you may know a family member or friend with a New Year’s resolution to reassess or modify their current investment program. As I wrote in July, clients have been inquiring if there is flexibility with our new account minimums. The answer to this question is yes. If you have children, family members, or friends you believe would benefit from our investment counsel and our focus on blue-chip dividend-payers, please encourage them to give us a call or send an email. We are happy to help.

* Rankings published by magazines, and others, generally base their selections exclusively on information prepared and/or submitted by the recognized advisor. Rankings are generally limited to participating advisors and should not be construed as a current or past endorsement of Richard C. Young & Co., Ltd.

October 2020 Client Letter

A combination of market volatility, political and economic uncertainty, and many unsettling events in the U.S. have delivered one of the most challenging and unusual years we have faced as investors. The year began on a positive note. In January, annual GDP growth was expected to be about 2%, unemployment rates were near all-time lows, and the most concerning headline for the markets was a trade war with China. All in all, we were cruising along nicely.

And then a black swan hit when the global economy was shut down in response to COVID-19. For good measure, the U.S. added trillions of dollars in stimulus, short-term interest rates were cut to zero, riots and burnings ensued, and we witnessed a circus of an election season. It’s enough to make one wonder how all these events could possibly be compressed into a mere eight months.

While the stock market has rebounded significantly from its March lows, and third-quarter GDP rebounded at a 33%-plus annual rate, there is nothing stable or certain in the world in which we currently invest.

Instability an Ever-Present Danger

Where might instability strike? COVID and the evolving reaction to COVID remain top of mind as a potential risk to stability. But the risks with the most impact are often those that few are thinking about.

A prolonged period of easy money is one risk we worry about. Easy money isn’t a risk in and of itself, but prolonged periods can act as a magnet for black swans (rare but impactful events). Easy money sets the conditions for risk to build, unnoticed, or underappreciated, in the system.

Risk-seeking behavior may increase more this cycle than in past cycles. During the spring, we had perhaps the biggest bailout of speculators, hedge funds, and over-leveraged companies in history. It is unlikely these actors have been humbled by their near collapse. On the contrary, many have likely been emboldened to take more risk. The red lines of who will be bailed out have been thrown out the window. Even formerly prudent investors may be letting down their guard on proper risk management.

Federal Reserve Bank of Boston President Eric Rosengren has pointed out the risks associated with prolonged easy money. Mr. Rosengren believes today’s loose policies have created an unstable buildup of risk in the financial system.

Rosengren opposed the Fed’s effort to bail out the stock market in 2019 with low-interest rates and now believes low rates are having a negative impact. Rosengren pointed to a buildup of debt in the commercial real estate market and other sectors. The reach for yield from low rates within these sectors may have allowed problems to fester. He said:

The increased risk buildup, such as the reaching-for-yield behavior in commercial real estate or increased corporate leverage, make economic downturns including this one more severe. These are issues that I and others spoke about quite extensively in the years before the pandemic hit.

If we expect to remain in a low-interest-rate environment for a protracted period of time, we need to take more precautions against financial stability risks for when the next economic shock hits.

Concentration Risk of Market

The concentration of the companies driving the stock-market rebound is also a risk to stability. We often think of the stock market in terms of specific indexes such as the Dow Jones Industrial Average or the S&P 500. The Dow is a price-weighted index of 30 companies, with the top five accounting for 30% of the value of the index. The S&P 500 is market value weighted, and its top five names account for 23% of its value. One sector—and one that is most unfriendly to the income-oriented investor—accounts for nearly 40% of the S&P 500.

Both the Dow and the S&P are up YTD, but take out the top five names in the S&P 500, and it would be down about 1% for the year. A broader look at markets shows that the perceived stability and complacency some have in the stock market may be unwarranted. As the table below indicates, an index of dividend stocks is down YTD, as is an equal-weighted index of the S&P 500. Small stocks and the NYSE Composite index are also down on the year. What would happen to the perceived stability of the market if the top five stocks in the S&P 500 cratered? Healthy stock-market recoveries are broad-based recoveries.

Benchmark Investing Counterproductive Today

For many reasons, index investing is a strategy we find counterproductive today. Paul Woolley, writing at the Financial Times, explains some of the problems with index or benchmark investing:

All investing boils down to a choice of two distinct strategies implemented in a variety of ways. One is buying securities that are priced cheaply in relation to their expected future cash flows, which is what everyone assumes is done with their savings.

Bizarrely, the other is almost the exact opposite: buying securities whose prices have recently been on the rise or that have already gone up most, both without reference to fundamental value. Another version of this, though present on a lesser scale, is selling assets that have recently been going down in price.

This second strategy has its origins in what might justifiably be termed “the curse of the benchmarks”. Most large funds delegate to external asset managers by setting index benchmarks, often with limits on how far returns should stray from the index return. Benchmarking is now shown to amplify mispricing by forcing managers to chase prices instead of fundamental value.

Trend-riding momentum investors successfully game this response, pushing prices higher knowing that benchmarkers are likely to come along later and be prepared to pay more. Price-only investing explains much of what is going wrong in financial markets. It is also the essence of short-termism.

When investors obsess about prices, corporate bosses are encouraged to do the same. With the added incentive of early-exercise stock options, they seek to maximize the company’s share price instead of building the business for the future. Among the ways to do that are reducing capital expenditure and research and development, focusing on quick pay-off projects, share buybacks, and raised debt levels.

In our view, it isn’t investing unless it is done with reference to fundamental value. Speculators focus on price. Investors focus on long-term value. As my dad’s late friend Dave Hammer (RIP) once put it, “If you don’t know what something is worth when you buy it, you will never know when to sell it or when to buy more.”

What Type of Outlook Should Investors Adopt?

If you are like most investors who are in or nearing retirement and you rely on—or hope to rely on—portfolio income, you will need to continue to invest a certain percentage of your portfolio in stocks. Due to the extremely low-interest-rate environment, hunkering down with a sizeable commitment to safer securities such as CDs and short-term Treasuries may not be the best move. After inflation, short-term CDs and bonds are in the red. And there is no sign that will change for at least a few years.

At its recent FOMC meeting, the Fed gave strong indications it will keep short-term interest rates near zero for the foreseeable future, which could mean through 2024. If that scenario plays out, CDs and short-term Treasuries will offer essentially no return for three-plus years. No return is better than a loss, but it is not a long-term strategy for generating income or compounding wealth.

Focus on Quality

Our strategy for the period ahead remains as consistent as it has always been. We plan to invest in dividend-paying stocks with a record of making regular dividend increases.

Companies such as Union Pacific and Johnson & Johnson are the types of businesses we favor.

Union Pacific

Union Pacific Corporation is a railroad company incorporated in 1969 but with roots back to 1862 when President Abraham Lincoln signed the Pacific Railway Act. The Union Pacific Railroad was one of two companies charged by the Act with the task of laying 1,912 miles of track from Omaha to Sacramento to create the Transcontinental Railroad. Today, UNP’s tracks cross 32,200 route miles. Many run through difficult-to-replicate rights of way that UNP has held for decades. Startups would be hard-pressed to compete in areas where UNP already has a unique presence. Today, UNP’s shares yield 2.22%, with plenty of money on the balance sheet to pay dividends.

Johnson & Johnson

Another company that meets our criteria is Johnson & Johnson—founded in 1886 by Robert Wood Johnson, with his brothers James and Edward, to produce antiseptic surgical dressings and sutures. Today, Johnson & Johnson is the world’s largest and most broadly-based healthcare company. Johnson & Johnson has a strong dividend record, having increased its payout each year for the last 55 consecutive years. Over the last ten years, Johnson & Johnson’s board has increased the dividend at an average rate of 6.87%. Johnson & Johnson is at the forefront of research on treatments and vaccines for COVID-19. The company has tasked its four innovation hubs in Boston, London, San Francisco, and Shanghai with working alongside startups and entrepreneurs to develop next-generation pharmaceuticals, medical devices, and consumer products to solve the world’s health problems. The innovations of today are meant to secure Johnson & Johnson’s competitiveness for years to come.

Both Johnson & Johnson and Union Pacific possess many of the characteristics we look for in our equity portfolios:

• High barriers to entry and durable/proven business models where we have a level of comfort around what the economics of the business will look like in 5 to 10 years;
• Strong balance sheets and/or readily available access to capital markets;
• Reasonable valuations given the growth characteristics of the business; and
• Higher yields over lower yields and higher dividend safety over lower dividend safety.

In contrast:

• We tend to avoid industries with high risk of disruption or structural challenges; and
• We avoid long-shot situations.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Gold prices have soared YTD, handily outperforming most major and minor stock market indices.

Falling bond yields, a weaker dollar, risk of rising inflation, and a hedge against stock market and general economic turmoil are the likely catalysts for gold’s rise. We have owned gold ETFs in client portfolios almost since the first gold ETF was listed in the U.S. My dad’s history with gold and silver goes back to the 1970s. We view gold as an important component of a well-diversified portfolio, but moderation is the key. We would rarely advise more than a 10% weighting in gold. Gold is a hedge. It is an asset we would much rather see fall in price than rise, as falling gold prices are most often associated with rising stock and bond prices.

P.P.S. A friend of our family recently asked my dad for investment advice. This person was not looking for individual stock recommendations but rather looking for basic advice on strategy. Our friend requested the advice not be technical as it was going to be provided to a novice investor. Here is what my dad wrote:

• I rarely invest in stocks that pay no dividend.
• I also insist on long-term annual dividend growth. Over the long term, stock prices most often follow dividend increases upward.
• I don’t like companies with high P/E ratios. In fact, stocks with single-digit P/Es are most appealing.
• Consumer expenditures account for $7 out of every $10 of real GDP, so I use Vanguard’s broad Consumer Staples ETF portfolio as a handy shopping list for many of my individual stock purchases. This allows me to craft portfolios with an average yield of nearly 3%.

P.P.P.S. Consumer staples shares have long been among our most favored areas of the stock market for the conservative investor. The defensive nature of their businesses tends to help staples stocks hold up better during recessions than more cyclical businesses. Toilet paper, toothpaste, breakfast cereal, and groceries aren’t the most glamourous products, but they are purchased in good times and in bad. The reliable nature of demand for toilet paper and toothpaste, by example, allows staples companies to offer investors consistent dividend growth regardless of the current position of the economic cycle. In fact, more than a dozen consumer staples companies are members of the Dividend Aristocrats club, which comprises companies that have increased their dividends for at least 25 consecutive years.

P.P.P.P.S. Each year, Barron’s ranks the nation’s top independent advisors. Richard C.
Young & Co., Ltd. has been recognized on this list for nine consecutive years.*

* Rankings published by magazines, and others, generally base their selections exclusively on information prepared and/or submitted by the recognized advisor. Rankings are generally limited to participating advisors and should not be construed as a current or past endorsement of Richard C. Young & Co., Ltd. Barron’s is a trademark of Dow Jones & Company, Inc. All rights reserved.

September 2020 Client Letter

As you plan for your retirement, or if you are already retired, what is your primary financial consideration? For many of you, the primary reason to save and invest is to provide income during retirement. From what clients have told me over the years, planning for retirement and actually being retired require two different mindsets. For some, entering retirement is an adjustment that feels a little strange. For decades, individuals save and invest diligently, building their investment portfolio. Then retirement hits and, instead of saving, the drawdown phase begins.

We’ve always favored dividend-paying stocks because dividends are the fuel for compound interest. But, aside from the compounding benefit, dividends also offer the comfort of providing a relatively dependable and predictable stream of income, which can be a real boost during retirement years.

Income Seekers Face Uphill Battle

Today, crafting a portfolio with an income stream is not easy. Investors seeking income face an uphill battle. Investing in certificates of deposit (CDs) and Treasury securities to generate safe and secure retirement income is no longer an option. Intermediate-term Treasury notes yield just 0.27%. On a $1,000,000 portfolio, that is a whopping $225 per month in income. My electricity bill is more than that.

To make matters worse, if the Federal Reserve has its way, Treasury yields won’t rise meaningfully for years. The Fed recently announced that it is doubling down on its strategy of neglecting retired investors and savers to raise inflation. They didn’t use those words exactly. Jay Powell, the Fed Chair, couched the bad news in Fed-speak. He said that instead of targeting a 2% inflation rate as the Fed has done in the past, it will now target an average inflation rate of 2%. Moving forward, the Fed will allow inflation to run above 2% to make up for periods when inflation is below 2%.

What does the Fed’s new inflation strategy mean for you? To achieve this new goal, the Fed will leave interest rates lower than it otherwise would for even longer than it otherwise would. Whether or not this new strategy will work remains questionable. Part of the Fed’s problem is that it takes a narrow view of inflation, and its preferred inflation gauge uses non-market prices for about 30% of the index.

One example of the distortions created by the Fed’s use of non-market prices is in the price of housing. The Fed’s preferred inflation gauge uses an imputed (read: made-up) price for housing. Since year-end 2009, the price of housing using the Fed’s measure is up by 2.6% annually. Over the same period, the actual cost of housing, as measured by the Case-Shiller Housing Index, has risen by 4.1% annually. If the Fed properly measured the cost of housing, inflation would have been 0.30% higher than reported, and much closer to the Fed’s 2% target.

Cost of Retirement Income Never So Expensive

While the Fed complains about below-target inflation, it leaves out the cost of retirement income, which is arguably one of the most important prices in the economy. Unfortunately, investors saving for retirement or those in retirement don’t have that luxury. Thanks to the Fed’s zero-interest-rate-for-longer policy, the cost of retirement income has never been so high. David Rosenberg of Rosenberg Research in Toronto puts it this way:

As the boomers head into retirement age, what do they need? Income. What has this Fed strategy done? It has stripped the markets of income and forced investors into growth stocks. Those are long duration stocks. Retirees don’t need duration. They need cash flow.

Jim Grant, editor of Grant’s Interest Rate Observer, gives some thought to the particular sort of inflation experienced by the near-retiree:

I wonder if our monetary masters realise that they have created a rip-roaring inflation in the cost of retirement. The lower the interest rate, the greater the principal required. At a 5 per cent yield, a $1m nest egg delivered $50,000 a year. You need a fivefold larger egg to produce that at 1 per cent.

Generating retirement income from lower-risk assets will not be easy in the near term. Investors will likely need to be selective, tactical, and patient. Taking on more maturity and credit risk is also on the table because the Federal Reserve has left investors with no good options.

I don’t intend to sound too down on the yield environment, though. If you think in cycles, the upshot of today’s depressing yields is that we are coming off of an 8- to 12-month period of very strong performance for bonds. Better days and better opportunities will come in the bond market.

Boosting Dividend Income

To boost overall portfolio income, we have been working to upgrade the yield on our common stock portfolios. This is obviously a moving target as higher prices beget lower yields, but we are making progress. Some of the recent trades we have made to help boost portfolio yield include the sales of Texas Roadhouse and Cracker Barrel, which both suspended dividends due to COVID-19. We like both companies; but with the share prices having recovered substantially from the depths of the COVID-19 crash and no guidance on when dividends may resume, we moved out of both names and into higher-yielding alternatives.

We continue to favor common stocks that pay healthy dividends and have a record of making regular annual dividend increases. The chart below on Procter & Gamble stock illustrates the benefits of a dividend-focused investment strategy.

The chart shows the price of Procter & Gamble stock and the indicated annual dividend rate. Both series start in July of 1980 and are set equal to 100 on that date. Over the last 40 years, Procter & Gamble’s share price has compounded at a 10.5% annual rate, and the dividend has compounded at an 8.5% annual rate. As goes the dividend, so goes the stock price.

When you concentrate on dividend growth and stability, you don’t have to think about capital appreciation. Capital appreciation will take care of itself as long as the dividend is growing. Consider what would happen if P&G’s share price didn’t keep pace with its dividend. In July of 1980, P&G paid a dividend of about $0.12 per share. The split-adjusted price of the stock was $2.38. Today, P&G’s dividend is about $3.16 per share. If P&G was still trading at the $2.38 it traded at in July of 1980, the stock would yield over 132%. You probably have a better chance of getting struck by lightning than seeing a big blue-chip stock with strong dividend coverage, offering a yield of 132%.

Addressing the Decline in the U.S. Dollar

We view the scale of the monetary and fiscal stimulus recently undertaken, as well as the size of U.S. debt and deficits, as bearish signals for the U.S. dollar.

Some strategies being recommended to investors to diversify away from the U.S. dollar include investing in diversified international equity exchanged-traded funds (ETFs), currency ETFs, and hard assets.

What is our take on each of these strategies? As you know, we have long crafted globally diversified portfolios of individual common stocks. We favor an individual-security strategy over a strategy that uses broad-based ETFs, as it allows us to take a more focused and targeted approach. For example, we recently increased our allocation to international stocks by purchasing a basket of Swiss companies whose businesses are focused in Switzerland and Europe.

Swiss Franc Fundamentally Sound

What is it we like about Swiss stocks and the Swiss franc? The Swiss franc has long been viewed as one of the most fundamentally sound currencies in the world. The five-decade trend in the Swiss franc vs. the U.S. dollar is one of appreciation. Underpinning the franc’s strength is Switzerland’s low and stable inflation. I mean real low. So far this century, Swiss consumer price-inflation has averaged less than 0.50%. Contrast that with the U.S., where inflation that far outpaces Swiss inflation still isn’t high enough for U.S. policymakers.

Are Currency ETFs a Good Way to Diversify Internationally?

Currency ETFs are another way to diversify away from the U.S. dollar. We have owned foreign-currency ETFs in the past, but we don’t own any today. When we do invest in currency ETFs, we favor the currency-specific ETFs rather than the index or basket approach that seems more commonly promoted. When the yield environment allows for it, we also tend to favor foreign-currency-denominated government bonds over currency ETFs. You save on the expense ratio and, in many cases, own an asset free of default risk. With negative government bond-yields in many countries today, we haven’t been active in this market.

Our favorite currency is, of course, gold. We have a meaningful allocation to gold and silver for clients, and we added to those positions earlier in the year. With both metals up significantly YTD, a period of consolidation should be anticipated, but we continue to favor both for diversification.

Never Underestimate the Importance of Patience in Investing

The importance of patience to your long-term investment success cannot be overstated. Certain segments of today’s stock market are reminiscent of the dotcom bubble. Some glamour stocks have been rising 4% or 5% each day with no meaningful rhyme or reason. The fear of missing out may be pushing some stocks to unsustainable levels. The temptation to participate is surely there, but this is a dangerous and speculative game.

Take Tesla, for example: Tesla shares gained 74% in August to become one of the largest companies in the U.S. The sky was the limit… until it wasn’t. Investors who bought Tesla on August 31 lost 34% over the following five trading days. A 33% loss wipes out a prior 50% gain, and a 50% loss wipes out a prior 100% gain.

In the short run, sentiment matters much more than fundamentals. In the long run, fundamentals win out. Stocks can slowly climb higher over a period of months or years and then crash suddenly, wiping out much of the gain.

The same can happen in reverse. UPS is a stock we have invested in for years. Over the last five years, UPS shares have lagged the market.

Wall Street wasn’t happy that UPS was investing so much into its business to meet rising demand. Rising demand always seemed like a good problem to have, in our view. And we were happy to collect the 3% yield that was rising at a 5.7% annual rate while UPS invested more in its business. A 3% yield with an almost 6% dividend growth rate gets you close to a 9% total return.

What’s wrong with that?

Nothing, it turns out. Starting in May, UPS shares caught fire. Sentiment has shifted on UPS. Rising e-commerce demand because of COVID-19 was the catalyst. UPS shares are up more than 70% since mid-May. UPS investors are now ahead of the industrials sector and the S&P 500 since year-end 2015.

Impatient investors likely missed the boat here.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Of the top seven stocks in the S&P 500 accounting for 26% of the index, not a single stock trades at less than 33X earnings. Only three of the seven pay a dividend, and the average yield of the dividend-payers is 0.77%. For long-term investors, the S&P 500 should no longer be considered a useful benchmark to follow. On the other hand, if you are a trader or speculator, the S&P 500 may now be right up your alley. 

P.P.S. There is nothing wrong with people who want to speculate in the equity markets. Speculation has always been part of the financial landscape, and it always will be. The problem occurs when speculation is confused with investment. Speculating with your serious money is never wise. That is true even though some speculators make money some of the time—just as some gamblers make money some of the time. But, as we all know, the longer you sit at the roulette table, the greater are your chances of leaving it a loser. The same is true of stock market speculation.

P.P.P.S. Reporting on why the stock market is on shaky ground, Barron’s Ben Levishohn wrote on September 5:

Either way, a reckoning is coming. The Nasdaq has gotten too far ahead of itself for it to end any other way, despite protestations that the rise has been well deserved. Low interest rates make expensive stocks look cheap, and business models look unstoppable, and the looming threat of a coronavirus second wave makes tech stocks look all the more attractive.

“We believe this is the final and more-speculative stage of our summertime melt-up scenario,” says Chris Harvey, U.S. equity strategist at Wells Fargo Securities. “Experience suggests that at the tail-end of a melt-up funny things happen.”

P.P.P.P.S. Charles Ellis, investment consultant, former chair of the board of the Institute of Chartered Financial Analysts, and former director of The Vanguard Group wrote the book Winning the Loser’s Game: Timeless Strategies for Successful Investing. Ellis writes how the real challenge in portfolio management is how to manage risk.

Even though most investors see their work as active, assertive, and on the offensive, the reality is and should be that stock and bond investing alike are primarily a defensive process. The great secret of success in long-term investing is to avoid serious losses. The saddest chapters in the long history of investing are tales about investors who suffered serious losses they brought on themselves by trying too hard or by succumbing to greed.

July 2020 Client Letter

If you thought the FAANG stocks were hot, check out silver. The FAANG stocks may grab the headlines in the financial press, but silver has doubled from its March lows. Gold prices have also been in an uptrend. Gold hasn’t rallied as much as silver, but gold is trading at a new all-time high, and it is up an impressive 28% YTD.

As many of you know, we have long invested in precious metals and currencies for clients, even when it wasn’t popular. My dad’s interest in gold and currencies goes back even further. He recently wrote the following:

Gold’s 50-Year Price Explosion

I was there from the start. In early August 1971, I had just joined internationally focused research and trading firm Model Roland & Co.

On 15 August 1971, President Nixon shocked the world by announcing that the U. S. would no longer officially trade dollars for gold. At that time, gold’s fixed price was $35/oz.

By 1980, gold would hit an astronomical $800/oz.

OK then, back to Model and the firm’s wonderful head partner, Leo Model. From my first day onboard at Model, I started covering a bevy of major Boston institutional accounts. I was 30 years old, and I would become friends with analysts, portfolio managers and traders at Wellington Management, Fidelity Investments, First National Bank of Boston, State Street Bank, State Street Research, Endowment Management, Studley Shupert, and Keystone Management through my entire investment career on Federal Street in Boston.

I immediately realized that international trading (including gold shares and arbitrage), as well as monetary strategy and world currencies, was going to be my focus from August 1971 onward.

Five decades later, these subjects remain today my daily focus. I have been a buyer of gold, silver, and Swiss francs for decades, and I have never sold a single one of my positions.

By 1972 I was off to London on a mission for Leo Model. My job was to produce a strategy report for Model, Roland & Co. on the international gold shares market. It took eight days in London to meet all the insiders with whom Mr. Model had arranged visits. Except for a single, most unpleasant glitch (understatement), all went well.

I went on to submit a 25-page strategy report to Mr. Model. Shortly thereafter I was informed that Mr. Model had sent my report along to the firm’s chief monetary guru, one Edward M. Bernstein, one of the architects of the Bretton Woods monetary agreement.

Remember, I was 31 years old, and quite terrified to hear that EMB had been brought into the loop.

On 7 August 1972, I received the surprise of my young life: EMB wrote back on his corporate letterhead:

I think the collection of papers on gold is excellent. It seems objective and pointed. I have no suggestions. Put me on the list to get what you put out on gold.

Sincerely,

Edward M. Bernstein

Like many financial assets that have risen over the long run, the 50-year price explosion in gold hasn’t been a straight line. Gold has compounded at 8.5% since August 1971, which compares favorably to stocks and bonds; but as the table below shows, gold has also experienced long dry spells.

The 1970s were gold’s best decade, with the price compounding at more than 35%. Over the next two decades, gold was down in price. During the 2000s, gold prices soared again, rising at a compounded annual rate of over 14%. During the 2010s, gold didn’t perform as well as it did during the 2000s, but it kept pace with inflation and edged out bonds.

Historical Return of Gold, Stocks, and Bonds by Decade

We Buy Gold and Hope It Goes Down

Gold is the only asset we buy with the hope that it will fall in price. Why? Because, as you can see in the table above, when the price of gold is down, everything else in your portfolio is likely to be up. The 1980s and 1990s were a dismal time for gold, but they were boom times for stock and bond prices. Likewise, the 1970s and 2000s were a great time to own gold, but stocks were down in price, and bonds delivered modest returns given the interest rate environment at the time. During the 2010s, stocks boomed and, while it didn’t decline in price, gold was a laggard.

We would like nothing more than to be able to say with conviction that gold prices have peaked and are likely to fall over the coming decade. Sadly, no such claim can be made. The horse has left the barn with respect to the scale of U.S. debt, deficits, and monetization. Central bankers and politicians seem to be on track to print and spend until inflation smacks us all on the nose.

What’s more, the stock market, as measured by the S&P 500, has reached extreme levels of concentration and valuation reminiscent of major market-tops. Think 1929 and 2000. That’s not a prediction that the S&P 500 is poised for a sharp reversal, but we wouldn’t rule it out.

A handful of technology companies now dominate the S&P 500. Broad diversification no longer seems to properly describe the index. The technology sector’s share of the S&P 500 (we include interactive media and internet commerce companies) is now a staggering 39%. Technology has become a more important part of the economy, but the technology sector has also historically had the most companies experience catastrophic losses (70% loss with little recovery).

How much of your retirement portfolio are you willing to gamble on a handful of companies (mostly non-dividend-payers) and one sector with a spotty record?

In a recent MarketWatch article, “The Hidden Risk Hiding in your S&P 500 Index Fund,” Brett Arends quoted an economist and a money manager to highlight risks with the S&P 500 that don’t seem to be appreciated.

“The performance of stock markets, especially in the United States, during the coronavirus pandemic seems to defy logic,” notes Yale’s Nobel Prize-winning economist Robert Shiller. “With cratering demand dragging down investment and employment, what could possibly be keeping share prices afloat? The more economic fundamentals and market outcomes diverge, the deeper the mystery becomes…”
And as he points out elsewhere, the index right now is valued at 30 times average per-share earnings of the past decade. Prior to this year, it has only matched or exceeded that level twice since records began in the 1880s: In 2000, and 1929.

Arends continues:

Where does this leave the ordinary index fund investor? In a nutshell: Possibly exposed to fundamental index risks that they may not realize. They’re betting heavily on the FANMAGs. (If skyrocketing Tesla TSLA, now valued at nearly $300 billion, joins them maybe we can call them the FATMANGs).

“The notion that equity indexes are somehow risk-free states has to my mind always been a dangerous fallacy which has been amplified by the rise of passive investing,” comments Mark Urquhart, money manager at Baillie Gifford in Edinburgh, Scotland.

Actually, all three of the significant market crises which my career has contained—technology, media and telecoms (TMT), the financial crisis and now the coronavirus—have been linked by so much damage being done to particular parts of the index that it demolishes the thesis that index investing can diversify away such risk. 

Dotcom-Style Speculation

Valuation and concentration are not the only similarities to the late 1990s. We also see a level of speculation we haven’t seen since the dotcom era.

Tesla and other electric vehicle stocks seem to be the epicenter of this cycle’s speculative fervor. Tesla’s market value is greater than the combined market value of Toyota and Volkswagen. Together, Toyota and Volkswagen will produce about 20 million vehicles this year. Tesla will likely produce about 500,000 vehicles.

The EV dreamers will tell you that Tesla’s market value makes perfect sense and that the electric vehicle market will become a winner-take-all situation. Maybe, but we view that as a long-odds loser’s bet given that many global auto companies are national champions. If Tesla begins to dominate in EVs, foreign automakers will likely get government support. EVs are also likely to become extremely commoditized, as electric motors tend to be much simpler than internal combustion engines.

Don’t Confuse Speculation with Investment

There is nothing wrong with the people who want to speculate in Tesla or other stocks. Speculation has always been part of the financial landscape, and it always will be. The problem occurs when speculation is confused with investment. Speculating with your serious money is never a wise decision. That is true even though some speculators make money some of the time—just as some gamblers make money some of the time. But as we all know, the longer you sit at the roulette table, the greater are your chances of leaving it a loser. The same is true of stock market speculation.

Investing offers opposing odds. The longer you invest, the greater your chances of making money. Measured over a one-year holding period, the historical record shows that the odds of losing money in stocks is one in four, or 25%. Extend the holding period to 15 years, though, and history says the odds drop to 0. That’s right, since 1926, stocks have not lost money over any 15-year period.

Investment vs. Speculation

So how does one distinguish investment from speculation? According to Ben Graham, the father of value investing, “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

Graham’s definition is useful, but it leaves much open to interpretation. We would clarify the difference by saying speculation is concerned primarily with price, whereas investment is concerned primarily with value. Value is measured by a future stream of earnings, dividends, or growth in business worth. Philip Carret, author of The Art of Speculation and founder of one of the oldest mutual funds in America, explained, “The man who bought United States Steel at 60 in 1915 in anticipation of selling at a profit is a speculator. . . On the other hand, the gentleman who bought American Telephone at 95 in 1921 to enjoy the dividend return of better than 8% is an investor.”

Retirement Compounders Grounded in Investment

Our dividend-focused Retirement Compounders® (RCs) strategy is grounded in investment. We aren’t stock market traders or speculators. We don’t offer strategies for either approach. We buy only dividend- and income-paying securities in the RCs. The prospective yield on dividend stocks is known at the time of purchase, and a majority of dividend stock returns come from dividends and the reinvestment of those dividends. If we know the yield today and have a sense of how the income stream will develop in the future, we can make a judgment about a stock’s investment value.

Stocks lacking a dividend stream, and especially an earnings stream, require a crystal ball approach to divine what the future may hold. No, thank you.

When you invest in stocks that pay dividends today and offer the prospect of higher dividends tomorrow, price becomes an afterthought. By example, if you bought $10,000 worth of JNJ at year-end 1986, you would have earned $210 in dividend income during the first year you held the stock (the shares offered a 2.1% yield). In every subsequent year, JNJ raised its dividend. From 1986 to 2020, the dividend compounded at 11.9% annually.

Over that same time period, JNJ’s share price experienced six separate drawdowns (peak-to-trough declines) of more than 35%. A 35% drop is a significant correction and enough to rattle the cages of speculators and investors alike.

But consider this: If you held your shares for the entire period, that $210 of annual dividend income on your initial $10,000 investment would have increased to over $9,800 in 2020. Yup, JNJ would now be kicking off dividend income that is almost equal to your initial investment. Does it really matter that the stock fell over 35% a few times over the last 34 years?

That is the essence of investing.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Did you know that intermediate-term corporate bonds are up 5.4% YTD, as measured by the Bloomberg Barclay’s Intermediate Corporate Index? The Dow is down 6% for the year. During the height of the volatility in the spring, we shifted entirely out of Treasury securities and began buying individual corporate bonds. The prospective yields on corporate bonds have come down significantly from levels earlier this year, but they still beat the less than 1% yields on every Treasury security out to a 20-year maturity.

P.P.S. Dividend suspensions and cuts have mounted in 2020, but some firms are still increasing shareholder payouts. Kiplinger notes:

But if dividend hikes are a sign of fiscal strength during normal times, they’re a downright bold statement when they’re made in the middle of a recession. And some companies have indeed provided payout growth throughout the past couple of months—many of them with longstanding streaks, including several members of the S&P Dividend Aristocrats that have improved their dividends for at least 25 consecutive years.

Some of the companies we own that have increased their dividend this year include Johnson & Johnson, Procter & Gamble, American Tower, Medtronic, and IBM.

P.P.P.S. As a result of all the uncertainty from COVID-19, potential political risk (this is an election year), and global risks including a Chinese property bubble, investors are wise to maintain a balanced portfolio. Most portfolios we manage for clients contain a portion dedicated to fixed income and gold. Bonds and gold may not keep pace with stocks during a bull market, but they offer much-needed ballast in down markets.

P.P.P.P. S. We recently filed our Form CRS relationship summary with the SEC. This document is intended to inform retail investors about the types of client relationships and services we offer. A copy of our Form CRS can be found on the home page of our website, www.younginvestments.com, under the Relationship Disclosure link. We encourage you to review the document and contact us with any questions.

P.P.P.P.P.S. During the last several months, we have had investment strategy discussions with adult children of current clients. Some clients reached out, asking if there is flexibility with our new account minimums. The answer to this question is yes. If you have children or other family members you believe would benefit from our investment counsel, please encourage them to give us a call or send an email. We are happy to help.

June 2020 Client Letter

For over a decade, the reach for yield on Wall Street has been fervent, pushing some investors into making bad decisions. The insatiable thirst for yield spawned the slicing and dicing of mortgage-backed securities that led to a complex and confusing mess during the 2008 financial crisis. The Federal Reserve’s response to the Great Recession gave us the lowest Fed funds rate ever for many years. And today, thanks to the coronavirus, savers and investors once again face a most challenging fixed-income environment.

To counter today’s rock-bottom yields, we have been active with our bond portfolios. Seemingly overnight, the Federal Reserve slashed interest rates to zero and bought tens of billions’ worth of Treasuries and mortgage-backed securities daily. We responded by liquidating all our Treasury holdings, to be used for higher-yielding and higher-returning opportunities.

We have purchased corporate bonds at yields and spreads (yield advantage to Treasuries) that we haven’t seen in nearly a decade. Below are listed several of the bond issue purchases we made in recent weeks. You will note the maturity on some is much longer than we typically favor, but the yields and spreads were significant at the time of purchase. Higher yields and spreads drive down both the duration and the risk from a rise in Treasury rates. (Higher Treasury rates often coincide with narrowing spreads.)

Bond Purchases

Boeing 5.705% | Due 05/01/2040 | Rating: Baa2/BBB-

Boeing is a company that has been impacted significantly by the coronavirus. Flight capacity is down considerably worldwide, and new orders for Boeing aircraft will likely remain depressed for at least a year or two.

Boeing is, however, America’s largest exporter and a national champion. It is one of only two large commercial aircraft manufacturers in the world.

Our investment case on the Boeing bonds is that its minimum return is the 5.65% yield to maturity we locked in at the time of purchase. We are assuming that Boeing will not default. If business worsens significantly for Boeing, we anticipate a federal bailout of creditors. Money has already been set aside for Boeing in one of the stimulus packages passed by Congress. And if the federal government is willing to bail out small and large companies across the U.S., we believe America’s largest exporter would be offered similar assistance.

The potential upside we see over the coming years is in the range of a 10%–14% average annual return. How do we get to a double-digit return on bonds purchased at a 5.65% yield to maturity? In a more “normal” environment, we would expect Boeing bonds to offer a yield advantage to Treasuries of approximately 2% compared to the 4.5% yield advantage offered at the time of purchase.

If it takes three years from the purchase date for that to happen while providing room for long-term Treasury yields to rise, we estimate a total return on the Boeing bonds of approximately 10% per year. If it takes only two years for that scenario to unfold, the average annual return would be closer to 14%. There are, of course, no guarantees that Boeing will not default nor that the return on Boeing bonds will be positive over any given horizon.

Williams 3.50% | Due 11/15/2030 | Rating: Baa3 / BBB

Williams gathers, stores, and processes natural gas and natural gas liquids (NGLs). It operates refineries, ethanol plants, and terminals. Its interstate gas pipeline and gathering and processing operations span the U.S., including assets in the Gulf of Mexico, the Rockies, the Pacific Northwest, and the Eastern Seaboard. We purchased the Williams bonds at a yield to maturity of approximately 3.55%.

ViacomCBS 4.20% | Due 05/19/2032 | Rating Baa2 / BBB

ViacomCBS Inc. operates as a multimedia company. The company operates television and radio stations, produces and syndicates television and broadcasting programs, publishes books and online content, and provides outdoor advertising. ViacomCBS serves clients worldwide. We purchased the ViacomCBS bonds at a yield to maturity of approximately 4.4%.

Kraft Heinz 4.625% | Due 01/30/2029 | Rating Baa3 / BB+

Kraft Heinz is a household name. Kraft Heinz is one of the largest food and beverage companies in the world. The company’s brands include Oscar Mayer, Capri Sun, Ore-Ida, Kool-Aid, Jell-O, Planters, Philadelphia, Lunchables, Maxwell House, Velveeta, and, of course, Kraft and Heinz. We purchased the Kraft Heinz bonds at a yield to maturity of approximately 3.9%.

AT&T 2.75% | Due 06/01/2031 | Rating Baa2 / BBB

AT&T is also a household name, with operations in wireline and wireless communications as well as media and entertainment properties. We purchased the AT&T bonds at a yield to maturity of approximately 2.70%. 

Rising Dividends More Important Than Ever 

The threat of a prolonged low-interest-rate environment coupled with inflation due to our skyrocketing national debt means consistent and reliable dividend increases will be important. And searching for just the highest-yielding names is not always recommended. High yields can simply be a signal that a company’s weakness has driven its price down faster than management has been able to reduce its dividend. Consider this: Of the 10 highest-yielding stocks in the S&P 500 at year-end 2019, five have eliminated or reduced their dividend in 2020.

The stocks we purchase haven’t been exempt from dividend reductions or eliminations. Shutting down the nation’s economy full-stop is an unprecedented move that even some of the healthiest companies have struggled with. By example, Disney decided to forgo its June dividend to preserve liquidity, and will decide what to do about the December dividend later this year. (Disney pays dividends twice per year.) We do, however, favor companies focused on increasing their dividends regularly. A record of regular dividend increases is both a sign of company strength and management’s commitment to return value to shareholders. Both are essential for the successful dividend investor.

Dividend Stocks with Solid Payout Prospects, Safer Yields

Many of the companies we are buying offer, in our opinion, safer yields and solid dividend-growth prospects. These stocks include Caterpillar, McDonald’s, Medtronic, and Merck.

Caterpillar

Caterpillar Inc. (NYSE: CAT) is the world’s leading manufacturer of construction and mining equipment. Its products include excavators, loaders, and tractors as well as forestry, paving, and tunneling machinery. The company also manufactures diesel engines, gas turbines, and diesel-electric locomotives. Caterpillar’s business will be impacted by the recession, but cash-flow generation appears strong enough to weather the storm and maintain the dividend. CAT shares yield 3.1% today, and we expect mid-single-digit dividend growth over the medium term. 

McDonald’s

McDonald’s is a dividend stalwart. It has paid and increased its dividend every year since 1976. Few restaurants have even been around since 1976, let alone paid a dividend since then. McDonald’s shares yield 2.5% today. We are looking for the dividend to increase at a 5%–7% annual rate over the next few years. 

Medtronic

Medtronic is one of the world’s largest makers of medical devices, holding more than 4,600 patents on products ranging from insulin pumps for diabetics to stents used by cardiac surgeons. Look around a hospital or doctor’s office—in the U.S. or about 160 other countries—and there’s a good chance you’ll see Medtronic’s products.

Medtronic has increased its dividend every year for more than four decades, and its latest increase came in May. Over the last five years, the dividend has increased at a 12% compounded annual rate. 

Merck

Healthcare stocks are a classic defensive sector as consumers rarely cut back on prescription drugs just because the economy is in recession. Merck is a blue-chip pharmaceutical company and, like others, it is vying to develop vaccines and treatments for COVID-19. Merck shares offer investors a yield of 2.9%. In 2020, Merck hiked its dividend by 11%. 

What’s Your Investment Plan?

One of the keys to successful investing is having a plan in place and a portfolio suitable for your individual financial needs and risk tolerance. You do not want to be in the position of panicking and realizing too late that your nest egg’s strategy does not sync with your personality or financial goals.   

Know Your Risk Tolerance

To assist in creating your investment plan, establish how much risk you are comfortable taking. Do not take on too much risk if market volatility causes you too much stress.

The following Efficient Frontier chart compares risk and return for different asset allocations. The vertical axis shows the return earned for each portfolio mix of stocks and bonds and, along the horizontal axis, is a measure of how much risk was taken to earn those returns.

As you can see by comparing the portfolio of 80% bonds and 20% stocks to the 100% bonds portfolio, as portfolios take on a small number of stocks, the benefits of diversification lower risk and increase reward. Anything above the line is unachievable because no portfolios earning those returns are available at the corresponding risk levels. And any portfolios that fall below the line can be outperformed with the same amount of risk or have their returns matched with less risk.

But to achieve higher returns along the line, investors adding more stocks to their portfolios are taking on ever greater amounts of risk. A portfolio of 100% stocks boasts a standard deviation of 17%. With that level of risk, you can expect the market to lose that much about once every six years. That may be optimistic, given what stock investors have endured in recent years. Be aware of the risk in your portfolio and manage it wisely.

Patience

When you have an asset allocation suitable to your personal situation, it can be much easier to practice patience and ride out volatility. Patience can be an overlooked component of a successful investment plan. Patience allows you to participate in gains when markets rebound. You do not want to be on the sidelines when markets have those big, powerful rallies. And trying to time those rallies with consistency is nearly impossible.

As I wrote last April, if a buy-and-hold investor put $1 in the S&P 500 at the end of January 1970, he would have $141 today. If that same investor tried to time the market, but missed the best 10 months, he would have $44 today. If he missed the best 20 months, that $1 would be worth a mere $19 today. Market timing not only risks losing out on significant gains, but it also risks missing vital dividend payments.   

Don’t Forget Inflation 

When we think of risk, market volatility usually comes to mind first. But inflation risk is just as bad, if not worse. The long-term return for stocks includes all bear markets. Historically, stocks’ prices rise. So, when bear markets occur, they can be considered normal events that will eventually end. Inflation, on the other hand, does not end. Inflation is ugly and continually chips away at the purchasing power of your wealth.

Think of inflation as reverse compounding. Annual price increases of goods and services will slowly but surely make the grocery bill or nights out at your favorite restaurant much more expensive in future years. As time passes, the purchasing power of your savings begins to erode. This is one primary reason we all invest: to keep pace with inflation. The negative impact of inflation is also why we focus so hard on buying stocks that raise their dividends annually. Those annual increases help us keep pace with rising costs.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio. 

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. When my dad began writing monthly strategy reports in 1973, he emphasized an investment approach based on dividends, interest, diversification, patience, and compounding. Another proponent of compound interest was Richard Russell, editor of Dow Theory Letters. My dad subscribed to Russell’s newsletter for decades, and Russell wrote: 

Compounding is the royal road to riches. Compounding is the safe road, the sure road, and fortunately, anybody can do it. To compound successfully you need the following: perseverance in order to keep you firmly on the savings path. You need intelligence in order to understand what you are doing and why. And you need knowledge of the mathematics tables in order to comprehend the amazing rewards that will come to you if you faithfully follow the compounding road. And, of course, you need time, to allow the power of compounding to work for you. Remember compounding only works through time.

P.P.S. Retirement Compounders® (R.C.) is our globally diversified portfolio of dividend- and-income-paying securities. Currently, the R.C.s offers a yield of approximately 3.1% or 80% more than the rate of inflation. Aside from an attractive yield, we also prefer our stocks to maintain annual dividend increases. Recent increases were announced by Microsoft (+11%), Kroger (+14%), American Tower (+20%), Procter & Gamble (+6%), and T. Rowe Price (+18%).

P.P.P.S. Congratulations to you for staying the course during a wicked three-month stock-market environment. If the volatility was not bad enough, we have been truly tested with weeks of elevated uncertainty.

In his last interview for CNBC, Vanguard Group founder Jack Bogle reflected on the volatility of the 2008 financial crisis and the mindset investors should adopt during difficult periods: 

I always have said stay the course, and don’t let these changes in the market, even a big one that was a 50% decline, don’t let that change your mind and never, never, never be in or out of the market. Always be in it at a certain level and you may want to be 50% stocks like I am. You may want to be 75% or 25%. That’s probably a decent range. But never be out and think you can get back in because your emotions will defeat you totally.   

Staying the course can be easier to execute with a balanced portfolio. While you may not get rich from bonds, they do offer a counterbalance when equity markets head south. The same goes for gold. Gold pays no dividend and can have mediocre performance when equities do well. But during an investing lifecycle, gold certainly has its moments. This year is such an example.

P.P.P.P.S. Some professional investors eschew diversification. This crowd tends to subscribe to the philosophy that you should carefully pick the best eggs and watch them closely. But how many best eggs (ideas) can one have? The problem we see with this approach is that today’s best idea may turn out to be tomorrow’s biggest loser. That isn’t a problem specific to concentrated portfolios. There is often a disaster or two in every portfolio (even the ones we manage!). The trouble is that you don’t know which are the disasters ahead of time and, in a concentrated portfolio, a single wipeout can cause financial devastation.

Consider that just before the turn of the century, a concentrated stock manager may have considered Enron, Bear Stearns, Lehman Brothers, General Motors, and G.E. to be his best-ideas portfolio. All were Fortune 500 companies at the time; but looking back today, four went bankrupt and one has lost 85% of its value.

Proper diversification is essential to earning a return of and on capital. At Richard C. Young & Co., Ltd., we craft portfolios focused on cash flow. We diversify geographically and across industries, sectors, and asset classes in an effort to achieve both a return of capital and a return on capital.