Investors who continue to pile into high quality, income-paying companies with reliable earnings in light of the precarious outlook for equity markets have forgotten the meaning of risk, according to Geoff Legg, manager of the Kennox Strategic Value fund, who says these ‘bond proxy’ stocks carry serious valuation risk.
The stark outperformance of defensive equities over more cyclical companies has been one of the most prominent trends in equity markets over the medium term.
There have been a number of reasons for this, such as central bank policies forcing investors out of bonds and into the equity market as well as an overhanging sense of bearishness and nervousness within the market thanks to the fallout from the global financial crisis.
As such, companies that generate a reliable earnings stream, aren’t reliant on a booming economy to perform and have a safe and growing dividend have massively benefitted and delivered substantial returns.
A good example is the consumer staples sector, which has more than doubled the gains of the wider global equity market over the past eight years as investors have flocked to defensive stocks like Unilever, Procter & Gamble, Johnson & Johnson and Nestle.
Performance of indices over 8yrs
Source: FE Analytics
However, Legg – who has an FE Alpha Manager rating along with co-manager Charles L Heenan – says these stocks with bond-like characteristics are now highly overvalued and investors who continue to buy them thanks to macro uncertainty are seemingly unaware of the risks they are taking.
“We are still very wary of the income-compounding stocks,” Legg (pictured) said.
“These are the type of stocks investors have flocked to as they have consistently increased their dividend, but because of that have squeezed their dividend yields. People are still holding onto them, even though they yield just 2 to 3 per cent.”
“A number of these companies are paying their dividends with a leveraged balance sheet, and if they are starting on 30 times earnings, it compounds the issue.”
Legg and Heenan have a strict valuation discipline within their Kennox Strategic Value fund, as their core belief is the biggest risk to an investment is the price that is paid.
Like many value funds, however, theirs has struggled over recent years as the market has favoured companies that many deem too expensive.
However, Legg says investors need to remember that the past is no guide to the future and just because these bond proxies – which include consumer staples, utilities, mega-cap US tech and certain parts of the healthcare sector – have delivered the strongest returns over the medium term, that doesn’t mean it will continue.
“These types of stocks have had a very good eight years or 10 years, but we also believe that when areas of the market have performed well so for long, people will buy into them forgetting that it doesn’t make sense to pay 30 times earnings,” Legg said.
“These are the bond proxy type stocks that people view as ‘safe havens’.”
He added: “While many of these companies are very high quality, the valuations make them risky. It is just as risky to buy a high quality company on 30 times earnings as it is to buy a lower quality company on 10 times earnings.”
It is no doubt a difficult decision to buy into areas of the market that have considerably underperformed and that is one way you could describe traditional value stocks over recent years.
According to FE data, the MSCI AC World Value index has underperformed the MSCI AC World Growth index (which is heavily weighted towards ‘bond proxies’) by some 20 percentage points over five years.
Performance of indices over 5yrs
Source: FE Analytics
Legg isn’t the only manager to warn about a significant trend change in markets that may hurt cautious investors, with the likes of City Financial’s Peter Toogood arguing that no matter how one looks at it, value funds outperform from here.
He said recently that there are two outcomes that would see value outperform growth from relative perspective.
The first would be a 2008-style market collapse which would cause all areas of the market to fall, according to Toogood, but value would stocks would outperform growth as they would already be cheap going into the crash as few currently own them.
The second (and slightly more positive outcome) is if economic growth revives in the second half of the year.
“This is more reminiscent of 2005, when growth fears were replaced by hopes for stronger growth in the future. Value trounced growth that year,” Toogood said.
Legg and Heenan have certainly benefitted from their value style over the longer term, with their £190m fund comfortably beating the IA Global sector and the MSCI AC World index since its launch in July 2007.
Performance of fund versus sector and index since launch
Source: FE Analytics
However, those numbers include three consecutive years of underperformance between 2013 and 2015 as investors shunned value stocks and the managers held a consistently high level of cash due to their belief that most areas of the market had become well overvalued.
Nevertheless, the managers have stuck to their guns and have been rewarded during the recent market volatility. According to FE Analytics, Kennox Strategic Value has been the third best performer in its sector and beaten the index by close to five times in 2016 so far with gains of 10.03 per cent.
That performance has been helped significantly by two of the manager’s most contrarian calls – energy and gold mining.
The managers are particularly happy with the performance of their gold mining stocks, an area of the market that has been widely hated but Legg and Heenan started buying last year. For example, since November last year, the FTSE Gold Mines index has rallied 74 per cent thanks to low starting valuations and a bounce in the gold price as a result of investors losing faith in central banks.
Performance of indices since November 2011
Source: FE AnalyticsNevertheless, Legg and Heenan still hold 13.86 per cent in cash and just 24 holdings due to their view that there is still little value in global equities apart from the odd special situation and parts of the commodities space.