Investors are putting their capital at risk by buying defensive income generating equities, according to Argonaut’s Oliver Russ, though not because they could underperform as interest rates rise, but because future returns are now very much hampered given they are “very, very expensive”.
One of the major talking points in the industry over the past year is the outlook for defensive dividend paying mega-cap companies, which – thanks to the dependable nature of their income – have become increasingly popular with cautious investors who have been forced out of the bond market by central banks in search of a reasonable level of yield.
According to FE Analytics, the consumer staples sector, healthcare sector, utilities and REITs (which have all been dubbed ‘bond proxies’) have considerably outperformed the wider equity market over the past five years as fixed income yields have fallen thanks to ultra-low interest rates and quantitative easing.
Performance of indices over 5yrs
Source: FE Analytics
However, with talks of interest rate rises in the US and UK in the not too distant future, many experts say investors should avoid those areas of the equity market as their fortunes are now seen to be closely correlated to bonds – which are expected to struggle in a tighter monetary environment.
You would expect Russ, manager of the five crown-rated FP Argonaut European Enhanced Income fund, to have a similar argument given he is massively underweight the likes of consumer staples and healthcare, two areas which are highly popular with most equity income managers.
However, Russ says the major reason he avoids those areas is because given their current valuations, there is now a higher chance of losses than share price gains.
“It’s a yield thing, really. They tend to offer sub-market yields,” Russ said.
“You might expect an equity income fund to own those types of things but the problem now is they are very, very expensive on a yield basis as well as a P/E level. I don’t think I can justify owing them in this fund where I’m trying to maintain a high headline yield.”
For example, the manager says he has been selling down his exposure to the likes of Roche (a pharmaceutical favourite with the likes of Mark Barnett and Neil Woodford) due to its current valuation, though he admits it was a “heartbreaking” decision to make given its performance over recent years.
“But, I think part of the attraction of equity income funds is that it does put a valuation discipline on the manager and that hasn’t mattered one bit over recent years because the market has just gone up and things that were expensive have just got more expensive,” Russ said.
“At some point it will matter, though. Maybe we are reaching that point now, maybe we aren’t, but I don’t want to be caught holding stocks on 30 times earnings if suddenly the music stops. It tends to be the highest quality companies which are the most expensive, such as the steady secular growers.”
As mentioned before though, many experts – such as FE Alpha Manager Henry Dixon – warn these stocks will struggle because interest rates will rise.
“That doesn’t leave the bond market in a good place fundamentally. Bond yields could rise from the lows of 1.5 and potentially double because of inflation data that we could get in December/January. It would then follow that shares that have enjoyed ratings of 25-30 times could see five of their P/E points disappear very quickly,” Dixon said.
Therefore, the manager says investors could be looking at 20 per cent downside in these types of bond proxies.
You can certainly see why many are concerned, given the tight correlation between bonds and defensive equities – such as consumer staples – since yields on the likes of US treasuries began to rise sharply in April.
Performance of indices since April 2015
Source: FE Analytics
However, the likes of Evenlode’s Hugh Yarrow – who is massively overweight consumer staples in his five crown-rated fund – says investors shouldn’t be put off those stocks as they offer a good and growing source of income.
“Bonds don’t increase their distributions, good quality equities do. They also have pricing power so have the ability to hedge against inflation,” Yarrow said.
“Looking ahead, and assuming we are not off to the races again and assuming the economy remains quite tough, my view is that these types of stocks should be able to grow their dividends by mid to high single digits.”
Russ, however, sits between those two arguments.
For instance, he isn’t massively concerned about a rate rise as he thinks neither the US nor UK necessarily need to tighten policy given the strong deflationary forces elsewhere in the world. He also agrees that most of these high quality stocks won’t have to cut their dividends.
However, his view is that while these companies may continue to grow their dividend, the possibility of increasing income pay-outs won’t mean much to his portfolio if the share prices of those currently very expensive stocks start to fall.
“It’s more risk management, really,” Russ explained.
“I’m not massively concerned about a higher rate cycle in the US or UK because a lot more is being talked about it rather than actual action. We would be lucky to see a rate rise in the US this year and I will doubt we will see in the UK.”
He added: “It’s not the risk of a dividend cut, but the price you have to pay for that dividend.”
Russ has managed the £107m FP Argonaut European Enhanced Income fund since its launch in April 2010.
According to FE Analytics, the fund has been a top quartile performer in the IA Europe ex UK sector over that time with returns of 57.75 per cent, beating its MSCI Europe ex UK benchmark by more than 25 percentage points in the process.
Performance of fund versus sector and index since launch
Source: FE Analytics
The Argonaut fund, which is one of a very few in the sector to offer currency hedging, is currently the second best performing portfolio in the sector so far this year with gains of 13.95 per cent.
Instead of holding defensive equity sectors, Russ is currently running a large overweight in financials and more specifically with insurers rather than banks. His fund, which can also use covered call options to boost income, yields 3.9 per cent and has a clean ongoing charges figure (OCF) of 1 per cent.
