Many high-quality growth stocks have been unfairly branded as ‘bond proxies’ and, if their valuations continue to fall, could soon become attractive buying opportunities, according to Troy Asset Management’s Gabrielle Boyle (pictured). 
The manager, who heads up the four crown-rated Trojan Global Equity fund, says equities don’t have the contractual promises of a bond so the labelling of stocks as ‘bond proxies’ is flawed for the most part.
Not only this, she argues that not all stocks are alike and that many high-quality, dividend-paying stocks offer rare, compounding growth through reinvestment of their earnings at high rates of return.
“The Financial Times recently ran an article entitled ‘The long-awaited bonfire of the bond proxies’ highlighting the sell-off in companies that possess ‘bond-like characteristics’ on the expectation of increasing rates,” Boyle wrote in her latest fund newsletter.
“Quantitative easing and zero interest rates have driven the price of consistent, dividend-paying equities to uncomfortable levels. These distortions are just as aggressively felt when those same price-insensitive buyers seek a new home elsewhere.”
“We see this starkly in the underperformance of so-called ‘quality stocks’ in recent weeks. Whilst, in the near term, these gyrations make life unsettling for long-term fundamental investors like ourselves, some respite in valuations is welcome.”
“If this continues, items on our ‘shopping list’ of companies could soon move into buying territory.”
During the first half of this year, there was a mass move into fixed interest assets in a bid for regular income, sparked by the ultra-low interest rate environment. As to be expected, this forced fixed income yields to historically low levels.
Performance of indices in 2016
Source: FE Analytics
Investors subsequently flocked to mega-cap, dividend-paying ‘stalwart’ stocks instead and, as such, valuations in this market area rose significantly.
While many stocks that have been dubbed ‘bond proxies’ have fallen in value over recent months as bond yields have started to rise, Boyle says that many areas of the market have been unfairly sold off despite offering strong returns and positive fundamentals.
“The ‘bond proxy’ term is better used, we believe, in reference to those companies that depend on debt to finance low and stable returns on their capital, with limited pricing power, and which pay out nearly all their capital to shareholders in dividends,” Boyle reasoned.
“These are typically drawn from utilities, telecoms and real estate sectors which, owing to their inferior economics, are unlikely to be a feature of the fund.”
One sector that seems to have been drawn into the bond proxy debate, according to the manager, is healthcare.
The sector accounts for 19 per cent of Trojan Global Equity’s portfolio, with the likes of Medtronic, Novartis and US medical technology firm Becton Dickinson all featuring in its list of top 10 holdings.
Within this 19 per cent weighting, approximately 8 per cent is allocated to firms that sell prescription drugs.
“The pharmaceutical industry is peculiar in many respects,” the manager continued. “Supernormal profits are granted by patent exclusivity to reward the vast expanse of innovative research.”
“Profits are then quickly lost to generic copies once patents expire. The temporary nature of product profitability had drawn comparisons with other sectors that exhibit a similar pattern of feast and famine – oil and gas companies, for example, that must constantly find new wells as older ones run dry.”
“The comparison is fair, up to a point, and highlights the risk of capital misallocation that attends the search for the next blockbuster medicines. Yet the analogy can be pushed too far.
“The large scale manufacture and sale of prescription medicines is fundamentally a great business to be in, borne out by high and stable profits over decades.”
Performance of indices since start of data
Source: FE Analytics
Boyle points out that pharmaceuticals are far more profitable than consumer staples companies on average, while the capital intensity of manufacturing remains similar.
She says this is due to a combination of competitive barriers to entry stemming from brand loyalty, a legal framework that grants them oligopolies and stringent regulation required to bring a new drug to market.
She adds that, because of the jargon often used to described pharmaceutical companies’ business models, they are often overlooked by investors.
“Of course not all companies will succeed,” Boyle said. “To mitigate stock-specific risks we typically avoid small or specialist companies with narrow product portfolios.”
“Novartis, Roche and Johnson & Johnson, our three pharma holdings, all invest heavily in their futures and have a wide breadth of opportunity to continue to grow.”
“They also have other interests in healthcare beyond pharmaceutical drugs, in medical devices, diagnostics and over-the-counter medicines.”
“Their balance sheets are strong and they continue to increase their returns to shareholders in dividends and share repurchases.”
Over Boyle’s tenure, the £187m Trojan Global Equity fund has returned 77.63 per cent, which is broadly in line with its sector average and a 31.59 percentage-point underperformance versus its benchmark.
Performance of fund vs sector and benchmark under Boyle
Source: FE Analytics
That said, the fund aims to produce long-term returns without taking excessive risks and, over the same time frame, it is in the top decile for its downside risk – which predicts its susceptibility to fall during negative market conditions – and its maximum drawdown – which measures the most money lost if bought and sold at the worst possible times.