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Investors Going Overboard with Bonds

Pat Dorsey, CFA

Pat Dorsey: Hi. I'm Pat Dorsey, director of equity research at Morningstar.

Earlier this week, John Rekenthaler, who is joining me today, the vice president of research at Morningstar, e-mailed me an interesting little quote from an interview that Warren Buffett did on CNBC, and that's sparked kind of fascinating e-mail chain that we had. Why don't you tell me what the quote was, John?

John Rekenthaler: Well, Warren was speaking at Fortune's Most Powerful Women group or gathering.

Dorsey: Has Warren had an operation recently that I am not aware of?

Rekenthaler: Apparently, he is not one of the most powerful women, but he is definitely one of the most powerful men. He said that it's become quite clear to him that stocks are cheaper than bonds, which of course there was then a headline that tied in Warren to pronouncing on the bond bubble. I mean, there has been a lot of talk about a bond bubble.

Now, I didn't think he went that far when you look through there. He just said, he felt stocks were cheaper than bonds, and he couldn't see really any reason to add to a bond portfolio at this stage.

Dorsey: Right. That's the point that I think I've been making and you've been making as well a lot in communications we've had with investors, and certainly in videos I've done on the site--that why would you be settling for a 4% coupon that's fixed, for say, investment-grade debt right now when you could be getting a 7%, 8%, 10% coupon that grows over time on equities. It just seems like, as you put it to me, first grade math.

Rekenthaler: Yes. It's pretty straightforward stuff, and I'll touch on that.

But first, I guess, where I should start is pointing out that I always like how Buffett phrases things. And it's easy to say bubble, it's easy to say it, and it's easy to identify it looking backwards. It's hard at the time. The first few years I was at Morningstar had many people with many years experience in the stock market saying we were in a stock market bubble in 1989, 1990, 1992, and so forth, because they have these historic valuation measures and stocks were expensive compared to their measures, which always seem to have lots of data points in 1937 or something like that.

But the point being, I stayed clear off bubble, and I don't think it's a bond bubble. If we want to look at a bubble, we can look at 1950. I went back and looked at 1950. The yield on the S&P 500 was 7% and on Treasuries was 2.5%. Now, when you can get three times the yield on the stock market that you can on Treasuries, you're probably in an extreme situation.

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Dorsey: That was the dividend yield. The numbers I was referring to earlier were just free cash flow yields.

Rekenthaler: Right. This is the dividend yield of 7%. The free cash flow yield was probably 20% to 25% compared to 2.5%--10 times as much. So, we're not in that situation at all.

But I do think we're at the situation where, yes, it's time to stop adding the bonds, and we know from the cash flow figures, people are continuing to add to their bond funds, month in and month out. Well, folks, you are there already, enough with it.

Dorsey: Yes. I mean, it is fascinating. We were just talking before we started here about just how much things change, right? Bonds are now sort of the only place to be because, of course, they returned 7% annually in the past decade versus flat for equities. So, my gosh, they're going to do that going forward. I mean, it seems to me investors are making the same mistake they always do with chasing historical performance and doing today what they should have done 10 years ago.

Rekenthaler: Historical performance has such an effect upon the mind-set and how we view investments. I was thinking back into the late 1990s. At that time and it will seem very strange to the listeners I think right now, the argument that was in vogue was you never needed to invest outside of the U.S. Can you remember, can you think about that now and how that sounds now? You didn't need to buy emerging markets, you didn't need to buy into other countries.

You could just buy Coca-Cola, GE, and Motorola, and the great U.S. companies and you get exposure that way. But frankly, you probably didn't even really need to get exposure to those markets because the U.S. was the strongest economy anyway, and we were leading the new era and so forth.

Dorsey: And of course, you got better corporate governance here in the U.S. and better accounting standards. So, my goodness me, why would you ever actually invest in those rickety emerging markets, right?

Rekenthaler: Right. The Wall Street Journal had several articles that were written by their leading commentators making this point and saying international diversification is dead; they had one that said, you don't need to do that anymore. Well, this was a fine writer and it's a fine newspaper, but international diversification was hardly dead in the late 1990s. In fact, that was the time which you really wanted to be picking it up, given what happened over the next decade.

What was driven by that? Obviously, the S&P 500 had dominated, had crushed the international stock indexes over the previous five and 10 years entering that time period. And I think just those numbers, they just have such a powerful pull on the psyche, and they make any argument that seems to fall in line with the past few years' numbers, just becomes that much more intelligent of an argument. It sparkles to people; it catches the attention.

Dorsey: It seems like in both cases the arguments miss is your starting point in terms of valuations, since in 1999, you had GE trading at 40 times earning, Coke at 60 times, emerging markets trading at single-digit multiples. Fast forward to today, and you have got a bond market with Treasuries yielding 2.6, 2.7, which could go lower, but there is sort of a zero lower bound on that, I think. So it seems like in both cases investors are paying too much attention to what happened in the past and too little attention to where they are starting from.

Rekenthaler: That's what they say about our fund's star rating sometimes. But that's a different discussion. Yeah, I was looking at a stock that I own, I'm allowed to say, talk about the stock that I own, right?

Dorsey: Yes, of course.

Rekenthaler: It's a big stock, 3M, so I doubt the viewers will push up the prices and make me rich. But this would be an example on free cash flow. I'm getting 6% yield on free cash flow compared to 2.5% or so for a Treasury. Is the free cash flow on 3M more secure than a Treasury? No, but it's pretty secure. When you look year-by-year, the company has doubled over the last 10 years, and it's pretty hard for me to envision the scenario where the free cash flow 10 years from now will be lower than it is today. In a bad scenario, it's a coupon that goes nowhere.

Dorsey: Right, and I think that's the key point is that…

Rekenthaler: ... It's a 6% coupon.

Dorsey: In a video I did recently people were sort of saying, well, gosh, you really can't think about bond coupon payments the same as free cash flow yields because cash flow can go up and down from year-to-year, and that's true that it can vary from year-to-year. But if you think about it over a multi-year time horizon, and as you just did, think about it in that sense, it becomes a very different story.

It seems like investors are paying a very high almost insurance premium right now for the safety of knowing what they will get year in and year out, whereas they can think about it as what will I get over a five-year period, it may vary a little bit year-to-year, but they could make a lot more in the long run.

Rekenthaler: Right, exactly.

Dorsey: As Buffett said, I'd rather have a lumpy 15 than a smooth five any day of the weak.

Rekenthaler: And I think those are the numbers that we might be looking at right now.

Dorsey: On that note, I'll finish up. I'm Pat Dorsey, and thanks for watching.