When a major macroeconomic risk, such as the European debt crisis or the potential for a hard landing in China, hangs over equity markets, investors are often inclined to disregard company fundamentals.
Yet paradoxically, in an environment such as this, it becomes even more crucial that you focus on the individual companies you are investing in and the resilience of their profitability, including how diversified these companies are by sector and region.
Although there is great risk during uncertain times, there is also great opportunity for growth.
We believe that by concentrating on macroeconomic concerns, many investors are not only sacrificing potential growth opportunities when the market normalises, but are also putting capital at risk by being invested heavily in what could well be a bubble in the traditionally defensive areas of the market.
Equity income investing has historically had a bias towards the more defensive areas of the market, as the traditionally high dividend-paying sectors have been telecoms, pharmaceuticals, tobacco and consumer staples.
These sectors have performed particularly well over the past 12-months. It is our view that many companies in these sectors are now overvalued relative to the rest of the market.
Tobacco, for example, is trading at historic highs on a price-to-earning basis, which is leading to erosion in its dividend yield.
This is also true in other defensive areas of the market, including telecoms, utilities and consumer staples, leaving these more stable groups at a relative valuation versus the broad market that is well above historical norms.
These valuation concerns are most pronounced in developed world, mega cap stocks that are increasingly perceived as “bond proxies” by investors.
If one looks beyond the handful of mega cap defensives currently in favour you can find quality businesses at attractive valuations. In many cases these opportunities are found among smaller but still sizable companies and in the emerging markets.
Within the Lazard Global Equity Income
fund we look less favourably on strong-performing developed market telecoms and prefer emerging world telecoms, which trade at much lower valuations even though they offer greater potential for growth in dividends and the potential to benefit from the ongoing increase in the spending power of the domestic consumer.
And more broadly, emerging markets have for a long time been a major source of opportunities, as the addition of this less efficient asset class has historically enhanced the Alpha generation of a yield focus while making it easier to avoid concentration in the typical yield-generating sectors of the market.
In our view, the capital growth potential of a company is hugely important. We do not wish to downplay the severity of the challenges the global economy faces, but at the same time many cyclical stocks are trading cheaply and are well placed for a rebound if the macroeconomic situation improves or simply stabilises.
By way of stock examples that illustrate this point, a market-leading Brazilian banking franchise benefiting from the dramatic increase in credit availability in that country presents a real opportunity.
While economic growth rates have recently slowed in Brazil, it remains a dynamic economy with longer-term growth potential well above any developed economy.
This potential makes this particular stock’s P/E ratio of less than six and a sustainable dividend yield of more than 6 per cent quite compelling in our view.
There are also examples of quality mining stocks yielding 6
that offer huge upside potential in the event of stabilisation in commodity markets and a more positive outlook on Chinese growth.
While financials and mining stocks may appear high-Beta plays, we do still believe some caution is necessary in the current environment and we are focusing on quality companies that can keep paying high dividends even if the world economy worsens.
The key, in our view, is to maintain balance in the portfolio. We believe in combing cyclical companies that are very cheap and which we feel would display resilience should the global economy deteriorate, with defensive companies which are currently undervalued.
As a result, the Lazard Global Equity Income fund maintains a broadly neutral position on the direction of the market.
While the macroeconomic outlook continues to be a major driver of day-to-day stock price movements, this doesn’t mean forecasting the global economy has become any easier.
In fact, we would argue the current combination of fragile economies and unprecedented policy actions is particularly challenging.
Every investor should think very carefully about the make-up of their portfolio as we reach this juncture in the cycle.
Many may be inadvertently taking on greater risk than anticipated by overexposure to mega cap defensive stocks trading at historical high-valuation metrics.
We believe that diversifying one’s equity income exposure may be prudent, as it will provide the opportunity for greater leverage to the ultimate recovery in equity markets along with a robust income stream.
Pat Ryan co-manages the Lazard Global Equity Income fund. The views expressed here are his own.