Wednesday, March 30, 2011

Gold versus Dividend Stocks

Investors typically make money when the assets they own increase in value and/or when the assets they own deliver dividend, interest or rental income. When combined, income and price returns results in the total returns equation. One asset that has generated positive total returns every year since 2000 is gold. Investors who bet on the yellow metal have generated 17.70% annual returns over that period. Right now the precious metal is hitting all-time highs, as many investors expect that the amount of monetary stimulus by the Federal Reserve would create massive inflation in the US. This speculative frenzy is catching up quickly, as investors bid up gold through one of the many vehicles available to dabble – gold etfs, gold futures, physical gold etc. For example, one of the largest ETF's in the US with over 50 billion in assets is SPDR Gold Shares (GLD), which allows investors to easily gain exposure to gold.

In reality however, there are very few reasons to own gold, besides the expectations that it would hit some magical high point because the imaginary printing press of the FED would create massive inflation. Gold is typically perceived as a store of value and as a sort of international currency. When discussing gold investment returns however, it is obvious that years of great returns are followed by years of poor returns. It is important not to make conclusions based off a limited number of data sets exactly for this reason. Investors who chase gold higher, touting its investment performance over the past decade, should not ignore the fact that investors who purchased gold 30 years ago would have made only a 75% return. An investment in Treasury Bills or Certificates of Deposit would have outperformed the yellow metal over the same time period. So much for gold being a store of value. However, if we extend the investment horizon to include the past 36 years, we would notice that gold produced very decent returns overall.

So besides the fact that prices might go higher because of the imaginary FED printing press, why would investors want to buy gold? It is not a store of value, as its purchasing power has has been known to decrease over some periods of time ( such as the past 30 years for example). Gold is a decent store of wealth to hold on to during wars, persecutions and other unpleasant situations. However, unlike oil, there is no real economic reason to own the metal. Every year companies mine gold, create gold bars and coins, which are then stored at vaults. In the words of famous investor Warren Buffett “[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.

In addition to that investors who own gold, end up paying up either for storage and insurance, or management fees if they invest through a gold ETF. Gold does not produce any income, which is ironic since it is touted as a stable currency. Every currency, stable or not could generate some sort of income return over a period of time, except gold. That’s why gold is particularly unfit for those who want to live off their assets. It is true that investors could sell a chunk of their gold each year in order to meet their expenses, but this would leave investors with a diminishing amount of gold. The rate of decrease of the amount of gold holdings in your portfolio would depend on the fluctuations in the commodity markets, which have been analyzed for centuries by market technicians, astrologists without any breakthrough as to where the prices will go next. To most dividend investors, owning gold doesn’t make much sense, since it is not an asset that produces income or generates any profit or economic/social gain to society.

Owning gold makes as much sense as stocking up on toothpaste and calling yourself a toothpaste investor. I would much rather own an asset that not only could generate potential capital gains for me but also pays me to hold it. Dividend stocks are one such asset. The best dividend stocks have strong competitive advantages, which allow the companies to pass any cost increases to consumers, which lets them increase profits over time. This leads to a higher dividend payment over time as well, which provides an inflation adjusted stream of income. In other words, investors in dividend stocks would not have to sell off their holdings, in order to meet expenses. They could just pick the right dividend stocks, create a diversified dividend machine, and live off dividends. Some of the best dividend stocks that I focus on are great inflation hedges, as their dividend and earnings have grown at or above the rate of inflation over time. They produce real goods or services, that provide value to their users, who are willing to pay the right price for quality. I do not recommend purchasing Tylenol or Gillette products as an investment. I would much rather own the companies that produce those everyday products, and profit along the way.

The companies I have in mind include:

Kinder Morgan Energy Partners, L.P. (KMP) owns and manages energy transportation and storage assets. This master limited partnership has managed to boost distributions for 15 consecutive years. Yield: 6.20% (analysis)

National Retail Properties, Inc. (NNN) is a publicly owned equity real estate investment trust. The firm acquires, owns, manages, and develops retail properties in the United States. It has managed to boost distributions for 21 years in a row. Yield: 6.10% (analysis)

Philip Morris International Inc. (PM) , through its subsidiaries, engages in the manufacture and sale of cigarettes and other tobacco products in markets outside of the United States. The company has managed to raise dividends every year since it its spin off from Altria (MO) in 2008. Yield: 4% (analysis)

The Procter & Gamble Company (PG) provides consumer packaged goods in the United States and internationally. The company operates in three global business units (GBUs): Beauty and Grooming, Health and Well-Being, and Household Care. This dividend king has managed to increase dividends for 54 years in a row. The company keeps raising distributions like clockwork, as evidenced by the latest dividend hike of 9.50% in April 2010. Yield: 3.20% (analysis)

Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company operates in three segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics. This dividend aristocrat has managed to boost distributions for 48 years in a row. Yield: 3.70% (analysis)

The Coca-Cola Company (KO) manufactures, distributes, and markets nonalcoholic beverage concentrates and syrups worldwide. This dividend aristocrat has increased dividends for 49 consecutive years. Yield: 3% (analysis)

Sysco Corporation (SYY), through its subsidiaries, markets and distributes a range of food and related products primarily to the foodservice industry in the United States. This dividend champion has raised dividends for 41 years in a row. Yield: 3.70% (analysis)

Full Disclosure: Long all companies mentioned above. I don't own any gold.

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