Summary
Benjamin Graham, the father of value investing, used to publish a revision of “The Intelligent Investor” every 5 years.
In Chapter 1, he would advice the investor on the relative allocation between stocks and bonds, based on prevailing yields and market conditions.
We apply his thought process to the conditions seen in January 2018, which are not too dissimilar from those he encountered in 1964, and evaluate his recommendation at the time.
We find that in 2018 stock investment still appears preferable to bond investment, and make the case for a substantial allocation to cash.
Benjamin Graham, the father of value investing, used to write a revision of “The Intelligent Investor” every 5 years. In Chapter 1, he would advice the investor on the relative allocation between stocks and bonds, based on prevailing yields and market conditions.
Benjamin Graham and the latest revision of The Intelligent Investor
In this piece, we attempt to provide similar guidance to inform investors' portfolio policy in 2018.
Returns to be expected from common stocks
In the times of Benjamin Graham, dividends were the only form a company would share profits with its shareholders. But in the last two decades, stock share repurchases have caught up and even surpassed dividend payments as the preferred instrument to distribute excess cash to shareholders.
In comparing expected income yield from bonds and stocks to assess their relative attractiveness, we shall therefore add the expected buyback yield to the expected dividend yield in the case of equities.
The last data
Several things have changed since then:
Real growth and inflation have increased nominal earnings by about 2% from June 2017 to January 2018.
US tax reform will cut the corporate tax rate to 21% from 35% in 2018. Analysts have estimated the ultimate effect of the tax cut on corporate earnings in the range from 7% to 10%. Note that these gains are much lower than 21.5% ((1-0.21)/(1-0.35)-1) since i) only a few companies were paying the full 35% corporate rate and will be paying the full 21%, and ii) part of the benefits from the tax cut will be passed through to employees, consumers and other stakeholders, depending on market forces. For this analysis, we are going to take 8% as the boost in US corporate earnings.
Putting all together, we estimate income yield (from dividends and buybacks) as of January 2018 at 4.15% (4.37%*1.02*1.08/1.16). This figure excludes the expected one-off special dividends and share repurchases following cash repatriation from companies like Cisco (CSCO), Netapp (NTAP), Qualcomm (QCOM), apple (AAPL), Amgen (AMGN), Oracle (ORCL), Microsoft (MSFT), Waters (WAT), Western Digital (WDC) or General Electric (GE) (given from larger to smaller overseas cash as percentage of market cap).
