Rational Investing: Stocks combat inflation as Treasuries cannot

The expectations for increasing interest rates are high among many, if not most, investors. That's in spite of a tame level of ination a nod from the Federal Reserve that leads one to infer that if there is a rate hike in November it may be the last one for several quarters and the quirky behavior of the markets that very often act in a manner counter to the perceptions of the masses.

Will rates stay where they are, in a narrow range? Will they start an upward spiral, fullling the prophecies of the gloom sayers? Will they confound the majority and decline further?

Fact is, no one knows not the politicians (least of all them), not the economists, not the high-prole bond fund managers no one.

So, what's an investor to do if he needs income? Here are some considerations.

As this is being written, the 10-year Treasury is yielding less than 4 percent. Compare that with the dividend yield on several issues of high quality common stocks, such as Merck (4.9 percent), Bristol Myers (4.8 percent), and Washington Mutual (4.7 percent). Granted, these three are in the news and out of favor (Isn't that when we are supposed to buy them if we believe in the "buy low sell high" adage?). Merck is all over the media with the Vioxx recall and the thundering herd of class action lawyers that are jumping on it. Bristol Myers is under the microscope for the number of drugs going off patent and subject to generic competition. Washington Mutual is perceived by the TV talking heads to be very vulnerable to rising mortgage rates that will cause home buying to slow.

Wow, who would want to own these issues?*

Here's the other side of that argument. First, one must recognize that these companies are not static entities, unable to adapt to changing industry or economic conditions. They have not achieved their success by sticking their heads in the sand. In spite of the criticism leveled on corporate America because of recent scandals in the halls of a few, many American companies have adjusted, changed tactics, sometimes strategies, to continue their successes.

Second and this is a simple but valid question compare the yields on these stocks to the 10-year Treasury and ask yourself which you would rather hold over the next 10 years, a Treasury that will guarantee you less than 4 percent yield (and not a penny more) or stock in a company paying a current dividend that produces more than 4 percent and has a history of regularly increasing that dividend.

Even if the annual rate of dividend increases are in the low single-digit range, they provided a means of combating ination, something that a xed-rate Treasury can't do. And the after-tax return is even greater, as treasuries are taxed at ordinary income rates while dividends are taxed at a maximum 15 percent rate. Are you a serious investor who recognizes that all companies have their ups and downs and who takes advantage of such opportunities when they occur within the context of long-term investing?

OK, so you are really nervous taking that approach: what about TIPS (Treasury ination protected securities), government-guaranteed issues that have interest rates that are adjusted for ination? If you think rates are headed higher because of ination, these may be appropriate, providing that their current low yield (1.7 percent) meets your needs.

In previous columns we have mentioned laddered maturities of bonds or certicates of deposit, a technique that calls for investing along the yield curve from the point of nearest need for an issue to mature to the point along the curve where it begins to atten, or at least lessen the steepness of its slope. This "attening" point is currently in the 10-year range; thus, if you have a need for cash in four years, you could invest roughly equal dollar amounts in issues maturing in 2008 through 2014. This technique allows you to annually adjust your xed income portfolio, thereby assuring that your entire portfolio will not be invested at the lowest interest rate. If the size of your xed income allocation allows, it is preferable to have issues that mature every six months.

This technique works well regardless of the direction interest rates take, and it provides a level of peace of mind that trying to time the purchase of bonds by placing all the funds in a single maturity doesn't. (You can monitor the yield curve by clicking on "Bonds" on the home page of Yahoo! Finance)

* We currently own, and may be adding to, these issues on behalf of our clients or our own accounts.

Clark Davis is a 34-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company.