Alan Steel: Ditch bonds and seek out dividends, as herds of US investors head for a fall

INVESTORS who believe history is helpful when making big calls in buying or selling shares will have avoided the volatile bumpy summer in world stock markets. For, on average, in seven years out of ten it makes sense to sell in May and go away. So history would imply it's time to start buying again.

For pessimists there's still plenty to worry about. From oil spills to floods and unemployment worries, the list is endless. So how about some good news. What does economics professor Jeremy Siegel think? In the past his predictions have been spot-on.

He published a book in 2005, The Future For Investors, comparing the performance of the 20 long-term survivors of the original S&P 500 Index launched in 1957. He tracked their share performance from then to the end of 2003.

The outstanding performer, with more than four times the return of any other company, was Philip Morris. $1,000 invested at the beginning, with reinvested dividends, would have grown to a staggering $4,626,402. That's a remarkable 19.7 per cent return per annum - almost five times what Warren Buffett received holding Coca-Cola shares. They only grew at 16 per cent per annum! Fifteen years ago when nobody wanted to buy Philip Morris shares because their customers - cigarette smokers - were suing them, I bought them. They were cheap because experts predicted the company was going bust. And experts, I find, are usually wrong.

Thanks to holding the shares for 15 years, and receiving dividends, not only have I trebled my original investment, but the gross dividend this year is about 19 per cent of the original investment. That's exceptional, but patience always pays off when you're investing for rising dividends.

Siegel has been a fan of dividend-paying quality companies for years. He's just published an article in the Wall Street Journal making investors aware of the potential for a bond bubble burst, which he reckons will be as devastating to investors as the great dotcom bubble burst in March 2000. He sees similarities now to then, when investors rushed headlong into dotcom shares despite the fact the income yield was almost zero. Right now in the US, some sovereign bonds are yielding 1 per cent gross, which was the yield of dotcom companies a decade ago. And we all know what happened next. Ten years later the Nasdaq is still down more than 60 per cent.

Meanwhile, Ned Davis Research reports that cash held in corporate balance sheets is at the highest level since records began 60 years ago. It's three times the level it was in 1982, just before shares took off in the Great Bull Market.

And it is also worth noting that the long-term pessimist hedge fund manager Crispin Odey has recently turned positive for a change. He also finds this liquidity highly attractive and sees great value in the unusually high yields available from some of the strongest blue chip businesses around.

Contrarians should also note that, in the last couple of years in the US, outflows from equity fund investments have come to more than $230 billion, and three times as much has piled into sovereign bond funds, or gilts and treasuries, if you prefer. History shows that whatever the herd loves will be the wrong place to be.

Sadly, recent research shows too many people still think it makes sense to invest in shares through index trackers. Research this week from Investment Boutique Scottish Value Management shows that over the last 80 years the top ten stocks in the FT Index underperformed the average of the whole index by 3 per cent a year. And data over the last 40 years shows even worse underperformance.

So what should cautious investors do? Research suggests interest rates will remain low, and with Siegel's warning about the possible gilt bubble bursting, and inflation picking up, I reckon it makes good sense to follow Siegel and Odey. The simplest way is to consider income funds which give a good income, usually rising each year, especially suitable for patient investors.

There are a few high-quality UK and international equity funds around which in some cases are yielding income of more than 7 per cent gross, with prospects for capital growth over the next few years. And sticking them inside tax-free or tax-efficient wrappers such as Isas makes huge sense for high-rate taxpayers.

Alan Steel is chairman of Alan Steel Asset Management, Independent Financial Advisers, Linlithgow