Asset Allocation: Slow and steady
They are not racy or sexy and they are certainly not the next hot thing. But Peter Taberner finds that ‘high quality' equities might suit investors' jaded palettes
To achieve certainty in an uncertain world is more than difficult, but even as the eye of the economic hurricane moves into the distance the merits of ‘high quality' equities (stocks with low leverage and reduced sensitivity to volatility and cyclicality) are increasingly apparent.
The low leverage and durable profitability models of high quality companies are fortified further by evidence that there are quality stocks that remain undervalued.
"Relative values have improved and currently there are undoubtedly undervalued stocks in large and mega-cap companies," says Chuck Joyce, lead manager for quality quantitative portfolios for GMO.
Commonly cited examples include global brands such as BAT, GlaxosmithKline, First Group and Vodafone, where increased investment will lead to dividend growth. Research firm Sandford Bernstein reckons that Vodafone is 40% undervalued, for example, following the market's rejection of its expansionist policy in investing into worldwide networks.
In addition, as interest rates have fallen high quality stocks have also gained a distinct yield advantage over government bonds. Morgan Stanley research highlights the progress that yields from the MSCI World Consumer Staples indices - a popular choice for low volatility funds - have made over the last 10 years in comparison to US Treasury bonds.
Fund managers are building defensive portfolios based on specific sectors, with regulatory environment, management techniques and innovation playing key roles in selection. Only large-caps in markets with high barriers to entry make the grade.
Bruno Paulson, a portfolio manager with Morgan Stanley Investment Management, whose Global Franchise Strategy has been running since 1996, says: "We have four major criteria for any investment and at any given time there tends to be just 25-30 stocks globally that meet the criteria. We start by looking for companies with a track record of high returns on invested capital. The company must have a durable intangible asset, such as a proven brand, licence or network. We require a strong management team committed to investing and innovating to support these intangible assets. Finally, we do not want to take the risk of paying too high a multiple of free cash flows."
Research on beta averages compiled by ING from the last five years reveals the sectors that have been the most robust through the turmoil. The least volatile has been healthcare (beta of 0.62 allied to a risk premium of 4.3%), followed by consumer staples (beta of 0.67 with a risk premium of 4.6%). Telecoms, discretionary, and utilities similarly exhibited beta averages of 0.79, 0.81 and 0.84 respectively. Another survey from State Street supports the view that consumer durables, on 0.69, and healthcare on 0.89 beta averages are the most defensive during a downturn, and both surveys agreed that materials and energy exhibited the highest betas. State Street's research also shows that a hypothetical portfolio of low volatility, value, high-quality stocks had a consistently lower price-to-earnings ratio P/E ratios relative to the MSCI World Index over the last 10 years.
Prime consumer staples are chocolate and tobacco - even the most depressed among us still have the means to buy both. Morgan Stanley research suggests that Nestlé sustained an organic growth rate of 5% over the 20 years to 2009. As return on invested capital has been high, earnings per share have risen fivefold over the same period (from CHF0.66 to CHF3.12), and the dividend has risen from CHF0.20 to CHF1.60.
However, long standing successful brands still have to face down developments in global markets, like the continued influence of M&A activity and influential emerging markets.
"Management and operational excellence are always high on our list when investing in defensives, and a long-term portfolio can increasingly be attached to emerging markets," explained Patrick Moonen, Senior Strategist at ING Investment Management. "Emerging markets are experiencing growth. There is the potential that increased discretionary spending could spark investing in, say, automobiles. There is room for luxuries as well as staples in developing countries".
Defensive strategies will use global franchises that trade in specific markets attractive to investors, rather than companies with fewer of these ‘quality' attributes that are simply listed on emerging market indices. In the case of the UK, defensive strategies can be considered ‘top heavy' due to the reliance on the FTSE 100, which produces around 90% of the UK's dividends. The problems of BP this year highlight the advantages of cross-border income funds with astute sector specific investing.
"Global investing is definitely rising and low volatility perspective should be adhered to in emerging markets, Europe and the US," says Mike Arone, head of product engineering for Europe, the Middle East and Africa, at State Street Global Advisors. "Any anomalies or inefficiencies in a global equity portfolio that may include small-cap companies or emerging markets can be eradicated by applying a risk budget that includes directing investments to fresh markets with budget surpluses, and growing consumption - but always with low volatility."
After the cataclysmic events of the financial downturn high quality stocks have undoubtedly become an attractive investment, and the expansion of global low volatility high quality funds seems testament to demand from investors for a less rocky road than they have suffered lately.