Why 100% Equities Isn't 100% Doable

Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.

Jason Stipp: I'm Jason Stipp for Morningstar. BlackRock's Larry Fink made some headlines this week by advising and urging investors to go all in stocks, 100% equities. Some early excerpts from Warren Buffett's annual letter also echoing a similar sentiment. Here we me to offer his take is Sanibel Captiva Investment Advisers president, Pat Dorsey.

Pat, thanks for joining me.

Pat Dorsey: Howdy, Jason.

Stipp: So, I think I know your answer to this, because we actually talked about this a couple of weeks ago.

Dorsey: We did.

Stipp: A 100%, all-in equities.

Dorsey: I think Buffett saw the video

Stipp: I think he did, too, I'm almost positive that he did. 100% equities is pretty extreme, but when you do look at stocks versus bonds, you can see why Larry Fink is saying this.

Dorsey: Exactly. Then again let's bear in mind that 75% of BlackRock's clients are institutions; they are not individuals. So let's just couch it in that framework. That's probably the audience he was speaking to. And certainly if you're an endowment or a foundation with essentially a perpetual lifespan, being very, very heavily in equities and very, very limited in bonds, just for liquidity needs, makes a ton of sense.

Stipp: We were talking about just recently in fact, after inflation, it could be a matter of actually losing money in certain fixed income versus hopefully making some money at least in stocks?

Dorsey: Exactly. That's the big thing that bonds don't do, is they generally don't protect purchasing power, especially not at the very low yields we have now.

The only way that a bond portfolio, say investment-grade bonds, is likely to protect your purchasing power and have a return that's positive after inflation over the next decade, is if inflation stays extremely low, 1% or 2%, for the next 10 years. Possible, not probable.

Stipp: Saying 100% equities is certainly a very robust and intriguing way of saying look, "stocks look really, really attractive right now," but for a lot of people who have a portfolio, who have different objectives, it's not necessarily going to be a realistic thing for them. When you're looking at a portfolio, when might it actually be a good idea, even if their return prospects look pretty dismal, to hold some bonds?

Dorsey: Well the first is, of course, liquidity. If you're sending your kids to college in two years, you need to have a lot of bonds, enough to fund that obligation. So bonds are always more liquid than stocks. They are not as volatile. Stocks can go through a rough couple of years, and you don't want to sell into a depressed market; bonds tend not to have those kinds of extreme prices. And so if you're paying for college in a couple of years, if you're a company that needs to fund retirement obligations, and so you constantly have this outflow of pension payments, you need to keep some bonds around to fund that on an ongoing basis.

Stipp: What about investor behavior? So, I know that it's not always the best idea to always let your risk tolerance lead your decisions, but we also do know that some investors just make bad decisions when things get really volatile.

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Dorsey: If you're someone who is prone to basically selling when the screen is red--after several bad months in the market, you just want to stop the pain, hit the button, and get out--you need to have probably some bonds in your portfolio just to buffer its overall volatility, because it's better to accept the lower expected return that, let's say, a balanced portfolio offers, and know you can stick with that plan, then, say, go all equities and then make a rash decision and sell into a depressed market. That would be a horrible way to go.

Stipp: Another thing I have to bring up, Pat, is that, I think if I were sitting here maybe even a year or so ago, or a little bit more than a year ago, I might also say, "You know what? Equities actually do look pretty attractive compared to fixed income." Yet, that's not exactly what we saw play out in 2011. So is there a case, a fundamental case, where actually bonds could continue to do pretty well, at least for little while?

Dorsey: Exactly. There are a couple of things here. One is, asset classes always tend to run further than you think. Investor behavior tends to reach extremes more often than not. So because of that, there are a couple of ways to think about this. One is, you're just not sure. You think that deflation is a real possibility, perhaps in the short run, perhaps in the long run. So, owning bonds that are going to benefit more in that kind of an environment ... Or say a calamity, a complete destruction of the eurozone, not just Greece leaving, but the whole shebang coming into pieces, Treasuries would protect against that much better than equities would. I think you could kind of think about a long-dated Treasury as basically a deflation put. So, if you have a bunch of equities over here that are going to benefit from inflation, then you have over here basically this smaller chunk of long-dated Treasuries that are just a put against a ... very deflationary environment.

Stipp: So if we have a comparison of stocks versus bonds, I think there's a lot of evidence that does point to equities certainly being much more attractive. What about on an absolute basis? If you were just going to look at the stock market on its own, would now be the time that you would put money to work?

Dorsey: There's plenty of cheap stuff out there. The thing to always remember is, it's not a stock market, it's a market of stocks. It's an old nostrum, but it's actually quite true in that you look at these overall indexes, and the index valuations are driven by Exxon, they are driven by Apple, they are driven by massive companies, and you kind of get down beneath the hood, and you can find cheaper stocks than the indexes.

So, the S&P overall is I think 14x right now, depending on which earnings estimate you really want to use, which is reasonably cheap given the low inflation environment we're in, the low interest rate environment we're in. But it's not like, early '80s, sell the house and buy stocks, seven times earnings environment. But when you look around, you've still got, for example, Cisco, which reported earnings just a couple of days ago. This is the tech company, not the food company, trading at about a 12% free cash flow yield, doing about $11 billion in free cash flow per year on about an $80 billion enterprise value. That to my mind is pretty attractive.

Stipp: Warren Buffett also commenting about what he likes to look for in the stock market. He mentioned that he likes productive stocks, he want stocks that have the ability, he said, in inflationary times to deliver output that will retain some kind of pricing power out there. He's also looking for, he said, non-capital-intensive businesses, although we did see him make some capital-intensive purchases.

Dorsey: Things have changed a little bit around Berky Hathaway with Burlington Northern; it's a topic for another day, perhaps.

Stipp: But looking at a broader level, what kinds of equities do you think, given that we could see inflation perhaps heat up maybe in the intermediate term or the longer term, what would you be looking for there?

Dorsey: You said it yourself, pricing power. Pricing power is really the key thing you want to look for, and these are the often businesses with moats, as we say at Morningstar. ... Disney has pricing power, Coke has pricing power, and Autodesk, which makes software for designing buildings and jet engines, has pricing power, because people get trained on it and can't switch to other software. But any business that can raise prices over time, ahead of its cost inputs is probably going to protect your purchasing power.

The only corollary to that I might offer is you also, if you can, want to find businesses that have good capital allocation. One of Cisco's issues, to return to Cisco, was frankly crappy capital allocation, buying Flip, buying General Instruments, and so forth. And they are still sitting on way too much cash. They need to be paying back more as the dividend, though they did hike it.

The kind of company I like to see is like CME Group, Chicago Mercantile Exchange. I literally could have walked down La Salle Street here [in Chicago] and kissed those guys a few days ago when they had their earnings report. They hiked their dividend 60% to about a 3.2% base yield, plus they are going to do a special dividend every year depending on how much money they made in the past year. Remember, this is a company that was growing at 30%-plus, and traded at 50 times earnings a few years ago. But that was when they were consolidating the exchange industry and they've realized that they are maturing now. Derivative volume does not go up 30% a year, and they don't need any capital for all practical purposes. So, your business changes, your capital allocation policy changes. Would that more companies would figure this out.

Stipp: A much faster maturity rate than you typically see?

Dorsey: Yes, definitely a much faster maturity rate. But also, they figured out when the capital allocation clue train boards, and they got on. Steve Ballmer is still looking for the train station.

Stipp: All right, Pat. I don't want to say that you heard it here first, but I'm going to go ahead and say it anyway. Stocks looking much more attractive than bonds right now. Thanks for being here and following up on that story today.

Dorsey: Appreciate it. Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.