ForeignExchange wrote:Charles Ellis discovered the advantage of utility stocks over bonds long before Lowell Miller.
This is helpful.
It suggests that utilities (or something like them) are a better choice than bonds in a balanced portfolio. I know that Lowell Miller makes that argument. The interest rate of bonds is so low these days that they are not worth being included in an asset allocation. (Lowell Miller did not include TIPS and/or ibonds in when he made his assessment.)
If you have a portfolio of multiple asset classes and if their fluctuations are not correlated (too much), your expected return is a little bit better than the weighted average of the individual returns (if you rebalance your portfolio periodically). If all of your asset classes have similar returns, this is great. But if one of them is a real laggard, including anything from that asset class brings the overall return down. Lowell Miller's real life experience showed that replacing the bonds of a balanced portfolio with utilities (excluding just a few obviously bad choices, but including some that encountered nasty surprises) enhanced his portfolio returns substantially.
What was new about Lowell Miller's study is that it compared utility stocks to other stocks.
One is rewarded for being an owner rather than a lender.
Bonds provide zero capital appreciation over the long-term, and a highly tax-inefficient income stream which struggles to provide a positive net real return for investors not tax shielded. Utilities will not grow at the speed of other types of stocks, but provide an essential service which will likely have value for decades to come. While the dividends may be taxable, the capital gains can be delayed. Indeed, the benefit of a partially to fully livable dividend stream reduces or eliminates the need to sell shares to release the capital appreciation element. A utility that grows by inflation, paying out 3-4% dividends is something that can happily provide livable income indefinitely. Volatility to the share price will become completely irrelevant, other than for companies that need a healthy share price to get bond issues approved in the future. Thus, a portfolio which contains a higher proportion of higher income payers as one comes nearer to the end of accumulation phase, can provide more assurance of market exposure. One can take advantage of the higher than bond return, but do an end-run around the volatility issue because it becomes largely irrelevant.
This would also be true for commercial real estate REITs or managed timber REITs, which each payout sufficent income from rents & timber harvests respectively, to live off. Other real assets such as oil well, gas well & precious/industrial/base metal investments can provide livable dividends but are depleting assets unless supplies are regularly replenished (as is the case with Canadian Royalty Trusts). Historically, utilities and real assets are not good growth investments. Over multiple decades one is likely to trail common stocks by owning a large chunk of them, but one does has to consider the risks of overvalued operating businesses in the present market combined with the limited growth prospects due to demographic issues. At some points, valuations in real assets will offer sensible rewards to the patient investor who wants the added reliablility of greater income streams. Outside of utilities and real assets, other businesses are available for investment which already temper their desire for growth, investing in the best growth prospects while sharing a healthy dividend with their shareholders. Not ideal when growth prospects abound and corporate responsibility avoids management enrichment via stock options & buybacks to fund same, but not all companies behave well. This again speaks to buying select businesses that display desirable characteristics, rather than index funds which mix the good, the bad and the ugly to lackluster effect in a low growth environment. Selecting other faster growing businesses into the mix should provide significant downside protection whilst outperforming the market as a whole with much more diversification to boot.