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Saturday, 23 October 2010

When Will the Madness Stop?

by Brett Arends

If you want to measure the level of craziness on Wall Street at the moment, take a look at what just happened to Wal-Mart Stores (NYSE: WMT - News).

This week investors were so eager to buy bonds they snapped up $5 billion worth of new Wal-Mart debt at pitifully low yields.

Yet they are showing comparatively little interest in Wal-Mart stock -- whose dividend yield just keeps getting better and better.

This isn't an isolated instance. Ordinary U.S. investors are flooding bond funds with new money, and those funds have to go out and buy these bonds at almost any price. At the same time, they are taking money out of stock funds -- and never mind the fundamentals.

Do investors really understand the risks they are taking with their money? Or the opportunities they are missing?

Take a look at the bond issue. Wal-Mart sold $750 million worth of three-year bonds paying 0.75% a year. It sold $1.25 billion of five-year bonds paying 1.5%, $1.75 billion of 10-year bonds paying 3.25% and $1.25 billion of 30-year bonds paying 5%.

Remember that those bond coupons are subject to two hidden costs. First, bond interest is taxed as ordinary income. That means that if the bonds are held in a taxable account, they will be taxed up to 35% right now -- and as high as 39.6% next year if the Bush tax cuts expire as planned.

Second, bonds face a serious risk from inflation. Who wants a piece of paper paying 5% a year for 30 years if inflation jumps to 7%? Nobody. If that happens, the price of the bond would plummet.

Now let's take a look at Wal-Mart stock.

At $54, it has barely moved over the past 10 years. Yet during that time the company's annual sales and net income have more than doubled. Net operating cash flow has nearly tripled. And dividends have quadrupled, from 24 cents to $1.09.

Okay, so it was overvalued a decade ago. Today it's 13.5 times forecast earnings. And the dividend yield is 2.2%.

It's not a king's ransom, but it's better than you're getting on those three- and five-year bonds, and not that far behind the yield on the 10-year.

Wal-Mart has raised dividends by an average of 16% a year over the past decade. If it merely raises them by 10% a year in the future, the yield on the stock will surpass that on the 10-year bonds within about five years. It will surpass that on the 30-year bonds within 10 years.

The company could raise those dividends more quickly if it chose. Its dividends are easily covered by its earnings and cash flow. And it is currently spending billions more buying back stock to boost investors' returns.

From the point of view of the investor, stock dividends enjoy two advantages over the bonds.

They are taxed lightly, at a maximum of 15%. If the Bush tax cuts expire completely, that advantage would disappear. But in the likeliest scenario, the tax cuts would continue for households earning less than $250,000 or so a year. So for most ordinary investors, dividends would keep their tax advantage.

And dividends enjoy some inflation protection, too. If we see a big surge in inflation, stocks won't be a great investment. But they will be much better than bonds. And companies sooner or later get to pass on rising costs to consumers as rising prices. Dividends will tend to rise.

No one knows what inflation is going to be in the future. But, unbeknownst to most investors, the Treasury market embeds a forecast, and it's the best guess available. Right now, by comparing the yields on regular and inflation-protected Treasury bonds, we can see that the market expects 2% inflation over the next 10 years and about 2.5% over the next 30.

Now compare those forecasts to the coupons on the new Wal-Mart bonds.

Someone buying the 10-year bond is locking in a likely "real," post-inflation yield of just 1.2% a year. Someone buying the 30-year bond should expect maybe 2.5% a year over inflation. And these are pretax rates. It is perfectly possible that some investors, without realizing it, have just locked in a negative real yield -- in other words, they have made an investment that guarantees they will lose money after taxes.

What we are seeing is merely one example of the very "dumb" process by which so many ordinary members of the public invest their money. The problem is that they, and their advisers, are apt to separate "asset allocation" from investing -- in other words, they first decide to invest in bonds and then send money to a bond fund. The hapless bond fund manager then has to go out and "put that money to work," even in an overvalued market.

So, right now, investors love "safe" bonds and emerging-market equities, and they dislike U.S. equities. As TrimTabs Investment Research notes, "While U.S. equity mutual funds have redeemed $54 billion this year, global equity mutual funds have sucked in $62 billion. Emerging markets attracted the bulk of the inflow." Meanwhile, there's been a tsunami into bond funds -- surging to around $30 billion a month in the past few months.

Yet Wal-Mart stock surely offers a better bet than the bonds. The balance sheet is solid. Operating cash flow was $26 billion last year. Return on investment is 19%. As of the end of July, it had more than $10 billion in cash on hand.

And Wal-Mart stock offers an emerging-market play as well. A quarter of sales now come from overseas, with the fastest growth coming from China and Brazil. The company just opened its 300th store in China.

Yet U.S. investors don't want to hear about Wal-Mart stock. They're looking for "safe" bonds and exciting ways to invest in China. Go figure.

Write to Brett Arends at brett.arends@wsj.com

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