Where to find value in the equity income market
Pat Ryan, co-manager of the Lazard Global Equity Income fund, says there are still many opportunities for investors in this area as long as they stay away from the “safest” names.
By Pat Ryan, Lazard
Tuesday October 30, 2012
We are frequently asked if high yielding stocks are now expensive, fuelled by excitement in the media about income stocks and strong inflows into equity income strategies.
While high yielding stocks have been outperforming within some individual countries recently, on a global basis this part of the market has been performing relatively poorly, with the MSCI World High Dividend Yield index lagging the traditional World index materially in 2012.
Performance of indices in 2012
Source: FE Analytics
The valuations of high yielders are broadly attractive relative to the overall market, although they differ significantly by region.
In aggregate, high yielders look expensive in the US, despite trading at a slight premium to the broad market; however, they have historically traded at close to a 20 per cent price-to-earnings [P/E] discount.
The overvaluation of yield stocks in the US is particularly pronounced among very large companies in defensive sectors.
In Europe, yield has consistently been a poorly performing strategy since the crisis, leaving valuations attractive, although many of these high yielding stocks will continue to be buffeted by the ongoing ups and downs of the debt crisis.
Emerging markets’ high yielders are trading below their long-term average historical relative valuations and look particularly attractive in light of low government and corporate debt levels.
As bonds have extended their multi-decade rally and reached unprecedented yields, investors have shifted capital out of fixed income as the rally has made valuations unappealing.
Much of this capital seems to have found its way to larger cap, defensive, high yielding equities. Both equity income funds and low-volatility strategies have seen substantial inflows in recent quarters, which have inflated the valuations of less volatile income stocks
This has been more evident in the developed markets and is particularly pronounced in the US.
US high yielding stocks from more defensive sectors have also recently become highly correlated to the movements in 10-year US government bonds, essentially becoming bond proxies.
Ironically, investors have shifted out of bonds due to unappealing valuations and yields, yet they have shifted the capital to equities that also look overpriced and are moving increasingly in lockstep with the bonds they just sold.
In the current environment of expensive defensives it is important to leverage a broad global opportunity set to find defensive businesses that remain attractively valued, either because they are smaller and more obscure, have had execution issues in recent quarters or are slightly more cyclical than the mega defensives currently in favour.
For instance, in the US telecoms sector we have reduced exposure to well-known companies such as AT&T and Verizon, as their yields fell below 5 per cent and their valuations moved to a premium to the broad market, and moved capital to CenturyLink, a smaller but still sizable telecoms firm with a market cap of roughly £15bn.
CenturyLink yields roughly 7 per cent and its dividend has stronger free cash-flow backing than the dividends of its larger competitors.
Capital One Financial in the US is attractive due to its highly profitable credit card business and recent acquisitions that materially increase its earnings power.
While banks are not normally thought of as defensive, the preferred share held in the fund is higher in the capital structure than common shares and generates a fairly low-risk 6 per cent yield.
Molson Coors is a North American-focused brewer that experienced execution issues in recent quarters, leaving it at a 40 per cent discount to the global beverages sector on a P/E basis.
Red Electrica operates the Spanish electricity transmission grid. While the macro outlook in Spain is challenging this company is fairly insulated from changes in economic growth and recent regulatory decisions have been favorable and reduced the risk of an adverse outcome.
Darden Restaurants operates the Olive Garden and other chains in the US and although restaurants are not immune to economic cycles, as people eat out less in tough times, Darden has been effective at reducing costs when traffic declines.
It also benefits from falling food costs during economic slowdowns, which has enabled it to generate annual earnings growth in each of the past five years, including throughout the financial crisis.
More attractively valued defensive businesses such as these offer better prospects for capital growth than expensive mega caps in nearly any potential scenario.
With equities generating little return over the past decade it is understandable investors are seeking a strategy that can generate tangible returns without the need for share price appreciation.
With bond yields at unprecedented lows and quantitative easing programmes from a variety of global central banks raising the potential for an uptick in inflation it is understandable that investors have looked to equities to generate income and initially focused on the least volatile, most bond-like equities.
But with valuations among this select group of defensive income stocks becoming unappealing, we would expect investors to rotate to more attractively valued income-generating equities.
Pat Ryan, is co-manager of the Lazard Global Equity Income fund. Over a five-year period the £205m portfolio has performed in line with its MSCI AC World benchmark, albeit with less volatility.
Performance of fund vs sector and index over 5-yrs
Source: FE Analytics
The fund is currently yielding 3.6 per cent, has a minimum investment of £2,000 and a total expense ratio (TER) of 1.55 per cent.
In an interview with FE Trustnet today, Cazenove’s Marcus Brookes said he has recently sold out of defensive equity income funds in favour of those that concentrate on capital growth.