STREETWISE: The case against investing in stock or bond mutual funds

This post was originally published on this site

As many readers of this column are aware, mutual funds, either bond or stock, are not discussed here. To answer the continual questions as to why, let me once again refer to an article in my archives from the New York Times delving into just that issue.

Dalbar, a Massachusetts research firm that has been studying the behavior of mutual fund investors for 25 years, reported that over a one-year period, and for periods of five, 10, 20 and 30 years, the average mutual fund investor has underperformed the markets for both stocks and bonds. Bond investors have generally failed to even keep up with inflation.

In the 30 years through December 2018, Dalbar found that the average bond mutual fund investor earned an average 0.26% annually, as compared to comparable inflation rate of 2.49%. Over the course of an entire generation, bond investors’ money shrank more than 2 percentage points a year in real terms.

This miserable record is not necessarily the fault of the bond market. The benchmark Bloomberg-Barclays Aggregate Bond Index returned 6.1%, annualized, over those 30 years. If you had held an index fund that simply tracked the bond market you would have earned about 6% a year, fees included.

The Dalbar results for 2018 are especially painful. The inflation rate was 1.93%, so investors would have had to earn that just that to tread water. Instead, the average stock fund investor lost 9.42%, for a gap of more than 11 percentage points.

Bond fund investors did a bit better. Their average investments declined “only” 2.84%, so they lagged inflation by more than 4.7 percentage points.

Data for stock mutual funds, when compared to the S&P 500 index, underperformed the index for a period ending December 2018 by 5.88% over 30 years, 3.46% over 10 years, and 4.35% over five years, according to the latest data I have available.

In other words, the average stock mutual fund investor has lagged the stock market, while investors in bond mutual funds have not kept up with inflation.

OK, so what about dividend paying stocks. Let’s look at what are referred to as the Dividend Aristocrats, or stocks that have been raising dividends for at least 25 years of which there are 65.

For 2020, ending June 30, the S&P 500 index had a return of -2.60%. The Dividend Aristocrats chalked up a return of -7.18%. For 2019, the S&P 500’s return was 31.49%, as compared to the Aristocrats of 29.90%.

A basic weakness of the Aristocrats is that the number of companies from which to choose is too few. Using companies with 10 years of increasing dividends raises the number of potential candidates to 327.

Regardless of which universe you decide to select from, remember you are only performing an initial selection of potential investments. From there, two other critical steps are necessary.

The first is to determine the intrinsic value of every company you select, whether a dividend achiever, an aristocrat, or even a company not in either of those two categories.

Next, you want to perform a discounted cash flow analysis using specific models, such as a free cash flow to the firm model, a discounted earnings model, or a dividend discount model. If you are quantitively oriented, consider using a free cash flow to equity model. Keep in mind that a dividend discount model is used extensively on Wall Street.

Regardless of which model(s) you select, you want the intrinsic value calculated to be higher than the current share price by a minimum of 5%. Not every model can or will meet the 5% criteria for a specific stock. However, if one or two of the models exceeds the share price by 5%, that is sufficient.

One web site that will calculate the free cash flow to the firm intrinsic value is ValuePro.net. However, some of the data for a company will need to be updated. Keep in mind that you are looking for a relative value. The extent to which the intrinsic value exceeds the share price is not particularly relevant.

Finally, remember that you still need to evaluate a company’s financial performance, supply chains, customer base and competition. Intrinsic value alone is a good place to start but is not sufficient.

You can write to Lauren Rudd at Lauren.Rudd@RaymondJames.com or call him at 941-706-3449. For back columns go to RuddInternational.com.