Why the World's Smartest Bond Expert Prefers Stocks

Ryan Fuhrmann's picture

Tuesday, July 5, 2011 - 1:00pm

by Ryan Fuhrmann

Pacific Life Insurance Co., better known to investors as PIMCO, was co-founded by Bill Gross back in 1971 and has grown into one of the largest and most well-respected bond managers in the world. As of the end of March, it managed nearly $1.3 trillion in assets. Gross is now a billionaire based on his ownership stake in PIMCO and remains at the helm of the bond giant.

PIMCO's success is due in large part to the investment genius of Bill Gross. Last year, investment research firm Morningstar named Gross the "Fixed Income Manager of the Decade." It cited reasons including timely and accurate calls on interest rates, currencies and that he "nailed the housing bubble," which helped investors in PIMCO's mutual funds avoid serious losses during the credit crisis. Investors have come to count on him and his experience of more than four decades in financial markets.

So why did the world's smartest expert say he prefers stocks instead of bonds right now?

Lately, Gross has been highly critical of the fact that low interest rates in the United States  aren't providing enough income for investors. He has been particularly negative on U.S. Treasury securities issued by the government. In fact, he recently said he views them as overvalued, based on his analysis of historical yields and his opinion that yields should begin to increase going forward.

Gross is largely avoiding Treasuries and has offered his insights on more appealing investment categories. Being a bond manager, it was logical for him to recommend fixed income alternatives issued by other countries, including Brazil, Canada and Mexico. But what really surprised market watchers was his recent advice for investors to consider buying dividend-paying Blue Chip stocks.

Compared to Treasuries, Gross thinks certain blue chip stocks are much more attractive alternatives. At a Morningstar investment conference in June, he specifically mentioned two consumer giants he liked: Procter & Gamble (NYSE: PG) and Johnson & Johnson (NYSE: JNJ). He also mentioned two utilities he found appealing: Southern Co. (NYSE: SO) and Duke Energy (NYSE: DUK).

P&G and J&J fit his criteria of global companies with stable operations that should be able to offer steady income for investors. Currently, both offer an above-average dividend yield of 3.4% and forward price-to-earnings (P/E) multiples of about 16 and 13.5, respectively. I would characterize these two stocks as a solid combination of appealing dividend income and reasonable valuations, with J&J looking more appealing because of its lower earnings multiple.

Southern Company's 4.7% yield is even more appealing, while Duke's is even higher at 5.3%. Looking at the P/Es, Southern Company's forward multiple is about 16, while Duke's is slightly below 14. Again, these are quite reasonable, but keep in mind utility companies tend to grow more slowly than others.

For comparison purposes, the dividend yields on these four firms are far superior to the income generated by investing in U.S. Treasuries. Below is a recent yield curve detailing Treasury yields...

As you can see, short term rates are next to nothing, with the 3-month yield literally at zero. The 3-year rate is marginally better at 0.83%, while investors would need to invest in a 10-year bond to get a rate above 3.00%. (The 10-year rate is currently 3.2%.) The 30-year rate looks decent at 4.4%, but requires locking up your money for three decades to get what is by historical standards a very low yield.

From a risk perspective, there are obviously major differences between U.S. government bonds and blue-chip stocks. Short-term U.S. Treasury securities are by definition risk-free, so in theory there is no safer investment out there. Stocks can be much more volatile and trade on the underlying fundamentals of the issuing firm. In other words, if P&G goes belly up, stock investors would lose all of their money. But realistically, this also quite unlikely.

Action to Take --> Given the extremely low interest rate environment, it makes sense to look for safe alternatives to U.S. Treasuries and hunt for yield. Given Gross's stellar investment track record, it's difficult to disagree with his view that allocating some of your portfolio to dividend-paying blue chip stocks makes great sense right now.

I am more bullish on P&G and J&J, given their abilities to expand in faster-growing overseas markets, but more income-minded investors might prefer the higher dividend yields of Southern Company and Duke. Barring another meltdown in the global financial system, blue-chip stocks should offer superior returns over Treasuries for investors willing to accept the volatility.

P.S. -- I don't know if you're aware of this or not, but a 20-year energy agreement between the United States and Russia is about to expire. The problem is, this deal supplies 10% of America's electricity. When the Russians refuse to renew the agreement, the U.S. will face an entirely new kind of energy crisis. This disruption could send a handful of energy stocks through the roof. Keep reading…

Ryan Fuhrmann does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.