The concerns surrounding so-called ‘bond proxy’ stocks have been hugely overblown, according to Evenlode’s Hugh Yarrow, who says the recent performance of his largest holding, Unilever, is a clear illustration of that.
There is little doubt that consumer goods companies have been phenomenal performers with the sector up more than 250 per cent over seven years compared with a return of 127.47 per cent from the wider UK equity market.
Performance of indices over 7yrs
Source: FE Analytics
Those returns have helped defensive equity managers to outperform their peers from both absolute and risk-adjusted return perspectives, with the likes of Yarrow, Nick Train and Troy’s Francis Brooke all having decent exposure to the sector.
However, many managers have warned that the outperformance has largely been driven by ‘tourist’ fixed income investors who have been forced out of bonds by ultra-low interest rates and quantitative easing into these defensive companies with reliable earnings and a steady dividend. 
They therefore warn that consumer goods are due a period of underperformance for a number of years.
The major criticism is that when bond yields inevitably rise, consumer goods will look far less attractive as investors will be able to find a safer level of income from the likes of gilts and corporate credit.
On top of that, they say slowing growth in emerging markets (many consumer goods firm have a huge amount of exposure to these) and increased competition from local players will hurt their business models.
However Yarrow – manager of the five crown-rated Evenlode Income fund – says fears of this ‘perfect storm’ have been over exaggerated and says the fact Unilever shares have rallied by 15 per cent in three weeks is testament to that.
“The reason for Unilever’s strong gains is because they released their third quarter trading statement and I think that concerns about the company’s emerging market exposure has been valid, given its accounts of 57 per cent of their sales,” Yarrow (pictured) said.
“I think it comes back to the fact that Unilever does have resilient demand for its products as even when the emerging market economic backdrop is tough, they have repeat purchase business as they offer low-ticket items that people habitually buy.”
“Yes, growth rates have slowed but their Q3 sales were up 4 per cent and their emerging market sales growth was up 7 per cent. That has been largely driven by volume growth but their pricing power has also helped.”
While emerging markets have been a source of bad news for Unilever, Yarrow says that as currency headwinds should start to dissipate and as the low oil price starts to feed through, the picture will start to look a lot brighter.
Yarrow had been buying more of Unilever during the volatile summer months, which means he now holds 8.03 per cent of his fund in the stock. This also means he now has the second highest weighting to the company out of all the funds in the IA UK Equity Income and IA UK All Companies sectors.
Source: FE Analytics
However, a number of other managers have questioned that sort of positioning this year. One of whom was FE Alpha Manager Henry Dixon, who said the outlook for mega-cap consumer goods companies was directly linked to the fortunes of the bond market.
“You have definitely had a change of trend. It is actually quite amusing when people talk of no liquidity in the bond market. If you rewind a week you could have liquidated your entire position in German bunds at 15 basis points now because it has hit that first bump in the road, liquidity has dried up,” Dixon said.
“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.”
Therefore, he says investors could be looking at 20 per cent downside in these types of bond proxies.
FE data shows the likes of Unilever have had a correlation of close to 0.4 relative to the Barclays Sterling Gilts index over three years. However, given the recent volatility in equity markets and the US Federal Reserve’s decision to not raise interest rates, many think bonds will perform okay which by extension would help the consumer goods sector.
Yarrow says, however, that investors need to rethink the way they view companies such as Unilever.
“We look at absolute valuations and the future free cash flow of companies and for Unilever it looks attractive,” he said.
“We don’t buy stocks relative to bonds. We look to insulate our portfolio from the macro rather than try and predict anything and the point that needs to be made is that good quality companies which grow their dividends are very different to bonds.”
“Unilever has grown its dividend by 10 per cent per annum over the last 50 years. However, this bond proxy argument has been discussed a lot over recent months and it has certainly been a volatile year for Unilever.”
Performance of Unilever versus index in 2015
Source: FE Analytics
He points out that even if interest rates were to rise, the likes of Unilever are well-placed to benefit from higher inflation due to their pricing power, strong balance sheets and low debt-levels.
Therefore he says the stock’s well protected 3.5 per cent dividend yield, as well as its recent dividend growth of 6 per cent, is an attractive proposition for investors. While its P/E ratio of 20 times has been used as a reason not to buy the stock, he says investors should know Unilever has been investing for future growth unlike many UK companies.
All told, Yarrow holds 33 per cent in consumer goods companies (making it his largest sector weightings) with the likes of Diageo, Procter & Gamble and Johnson & Johnson also featuring in his top 10.
He launched his £292m Evenlode Income fund in October 2009.
According to FE Analytics, it has been a top decile performer in the IA UK Equity Income sector over that time with returns of 99.85 per cent, beating the FTSE All Share by 35 percentage points in the process.
Performance of fund versus sector and index since launch
Source: FE Analytics
It has also outperformed in every calendar year over that time baring 2012, meaning it has been top decile for its risk-adjusted returns (as measured by its Sharpe ratio) and maximum drawdown since launch.
The fund, which yields 3.8 per cent, has also increased its dividend in each calendar year since 2009.
