The Elevated Risks of Safe Stocks
Normally safe, dividend-paying stocks have attracted major inflows, spiking prices. But their now elevated valuation multiples aren’t supported by earnings growth. The risks of a correction in these “expensive defensives” are running increasingly high as the threat of rising interest rates grows. Read our latest white paper “The Elevated Risks of Safe Stocks” for more details.
https://www.thornburg.com/pdf/TH3736_C_O_SA_ElevatedRiskOfSafeStocks.pdf
thornburg.com
|
8 7 7. 2 15 .13 3 0
The Elevated Risks of Safe Stocks
Traditionally safe, dividend-paying stocks have attracted tremendous
investor inflows, raising their share prices and valuation multiples to
levels that aren’t supported by earnings growth. The risks of a cor
-
rection in the “expensive defensives” are running increasingly high,
especially as the specter of benchmark interest rate hikes grows.
Executive Summary
•
Unprecedented monetary easing and asset purchases by major central banks have pushed
yield-seeking investors into dividend-paying stocks, driving up their valuations.
•
Earnings growth in the defensive sectors hasn’t supported the expansion in their valuation
multiples. The technical flows have been reinforced by the predominant capitalization weight
-
ing model in passive investing, which at its essence becomes a momentum trade.
•
Risks of a correction are growing, particularly in the U.S., where defensive stocks could
be hit if the U.S. Federal Reserve hikes rates sooner than later, as some Fed officials are
publicly advocating.
Charles Roth
|
Global Markets Editor
September 2016
2
|
The Elevated Risks of Safe Stocks
Mr. Market’s Mania
Four decades after the birth of Vanguard’s
ground-breaking index mutual fund and
the concurrent death of value-investing’s
father, Benjamin Graham, the allegorical
“Mr. Market” in 2016 appears to suffer
from bipolar disorder. What other diagno
-
sis can explain this summer’s record highs
in the S&P 500, the Dow Jones Industrial
Average, and the NASDAQ Composite
indices alongside record-low yields in
benchmark U.S. Treasuries? If equity price
highs suggest market euphoria, rock-bot
-
tom government bond yields imply market
panic. Is Mr. Market being efficient or irra
-
tional, complacent or anxious?
In Graham’s seminal 1949 book,
The
Intelligent Investor
, one of his precepts on
the market is that it should serve funda
-
mental, bottom-up investors, not guide
them. But six decades after its publication,
major central banks began trying to drum
up demand and ramp up the wealth effect
by chopping key interest rates and expand
-
ing their balance sheets through unprece
-
dented asset purchases. Their visible hand
has generated major pricing distortions,
creating considerable challenges for stock
and bond pickers and substantial risks for
passive investors.
If Mr. Market, the co-owner with the
active investor in a business or claims on
a public entity, is at turns emotional, effi
-
cient, and irrational, the U.S. Federal
Reserve (the Fed), the European Central
Bank (ECB), and the Bank of Japan (BOJ)
have been consistently uneconomic mar
-
ket participants: they’re buying designated
securities not based on attractive prices
relative to assessed values, but rather to
stimulate macroeconomic growth—to dis
-
appointing effect for several years running.
As a result of their “quantitative easing”
(QE) and flat or negative interest rates,
some $12 trillion in global sovereign
debt, mainly from Europe and Japan, has
now been priced to yield less than zero.
Central bankers in these markets have
effectively guided European and Japanese
fixed income investors into U.S. govern
-
ment bonds, which still offer meaningfully
more income return than global peers.
An after-inflation yield of half a point or
so on the U.S. 10-year Treasury certainly
beats paying governments in Europe and
Japan to lend them money. The ECB, BOJ,
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
10
12
14
16
18
20
22
24
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
P/E, Last 12 Months (Left)
Sales Growth (Right)
EPS Growth (Right)
P/E
EPS and Sales Growth
Source: FactSet.
Figure 1
|
U.S.
Consumer Staples Sales Slide as P/E Jumps
S&P 500 Consumer Staples Index
10
12
14
16
18
20
22
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
P/E
S&P 500 Index
S&P 500 Consumer Staples Index
20.45
16.89
Figure 2
|
Consumer Staples Forward Earnings at a Decade-High Premium to Market
P/E, Forward 12 Months
Source: FactSet.
The Elevated Risks of Safe Stocks
|
3
and the Fed have also herded many fixed
income investors into “bond proxies,” espe
-
cially dividend-paying stocks. These tra
-
ditionally “defensive,” steady-as-she goes
equities have led the stock market rallies
this year, a highly unusual occurrence that’s
now fraught with risk. Asset allocation has
rarely been more challenging than it is in
this environment.
Relative to the Broad Market and
Their Own History, Defensives
Get Expensive
At the end of the second quarter, the
S&P 500 Utilities Index led with a one-
year return of 31%, followed by the S&P
500 Telecommunications Services Index’s
25% and the S&P 500 Consumer Staples
Index’s 19% returns. The blue-chip S&P
500 Index’s overall 12-month return? Just
4%. Valuations in each of the sectors have
blown out, as the end-July projected earn
-
ings-per-share growth for 2016 in all three
lags considerably those one-year returns.
Indeed, in the telecoms sub-index, earnings
growth is expected to decline 12%, and in
consumer staples, rise just 4.4%, according
to S&P Dow Jones Indices. Price/earnings
multiples, unsurprisingly, have risen to tee
-
tering levels. Take the S&P 500 Consumer
Staples Index. As sales growth has trended
down over the last five years, earnings per
share growth has climbed sharply since
September 2015, thanks largely to share
repurchases. As yield-starved “bond refu
-
gees” moved in, the trailing P/E multiple
in March hit 22.2x, a level not seen since
2000. By the end of August, it ebbed to
20.3x, while the forward P/E was running
a hair above that, at 20.4x. Both the trail
-
ing and forward ratios were still well above
the 10-year, 16.7x average multiple for the
subsector. The 20% premium on forward
earnings at which benchmark U.S. con
-
sumer staple stocks are trading above the
broader index is at its widest level in nearly
a decade. (
Figures 1, 2
).
On a relative basis, monetary stimulus
in Europe and Japan has been even more
extreme than in the U.S., so the dynamic
pushing consumer staple stocks in those
markets has been more pronounced than
with U.S. sector peers. As the MSCI
EAFE Consumer Staples Index trailing
P/E multiple climbed to 22.2x at the end
of August, almost six points above its 16.5x
10-year average, EPS growth was falling.
-20%
-10%
0%
10%
20%
30%
40%
10
12
14
16
18
20
22
24
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
P/E, Last 12 Months (Left)
Sales Growth (Right)
EPS Growth (Right)
P/E
EPS and Sales Growth
Figure 3
|
International
Consumer Staples Valuation Lacks Support
MSCI EAFE Consumer Staples Index
Source: FactSet.
Figure 4
|
Mind the Gap: MSCI EAFE Consumer Staples Valuation Premium
P/E, Forward 12 Months
8
10
12
14
16
18
20
22
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
MSCI EAFE Index
MSCI EAFE Consumer Staples Index
P/E
20.90
14.68
Source: FactSet.
4
|
The Elevated Risks of Safe Stocks
MSCI EAFE Consumer Staples forward
P/Es were also hovering at their highest
levels in 15 years and were trading at a sky-
high 35% premium to the broad EAFE
Index. (
Figures 3, 4
).
Things aren’t much better on a global
basis among consumer staple stocks. The
trailing P/E on the MSCI All Country
World Consumer Staples Index was levi
-
tating at 24.3x, 5.6 multiple points above
its 10-year average. But it’s worth noting
that other global dividend stocks aren’t
as aggressively priced. The MSCI ACWI
Telecommunications Services Index’s trail
-
ing P/E was running at 18.4x, just less than
three points from its 15.5x 10-year average,
while the MSCI ACWI Utilities compo
-
nent P/E was nearly identical at 18.4x, two
points above its 10-year 16.4x average.
Where’s the Margin of Safety
Now? Passive Investors, Beware
Given the yield-chasing technical flows
driving returns in the “expensive defen
-
sives,” even as earnings growth lags, the
index weightings of the coveted dividend
payers have also swelled. The MSCI
EAFE Consumer Staples weighting, for
example, ballooned to 13.3% of the index
at the end of June, from 10.9% a year ear
-
lier. The yield seekers have also compelled
passive investors, ipso facto, to buy increas
-
ingly expensive securities in a self-reinforc
-
ing dynamic, despite the fact that doing so
runs exactly contrary to the age-old “buy
low, sell high” investment maxim.
So the risks for investors with elevated
exposure to the “safe” staples are running
high. The price appreciation and now rich
valuations leave little room for further
upside, but entail considerable downside,
which also runs counter to Graham’s “mar
-
gin of safety” precept. The crowds chasing
dividends have, of course, also driven div
-
idend yields lower. Continuing with the
MSCI EAFE Consumer Staples Index,
the dividend yield dwindled to 2.6% at the
end of August, down from 3.4% five years
earlier. The index’s payout ratio, mean
-
while, increased to 55% from 49% with
investors clamoring for dividends. Much
the same dynamic is evident among U.S.
blue chips, though more so with payout
ratios than dividend yields. Over the same
five-year period, the dividend yield of the
S&P 500 Consumer Staples stocks receded
to 2.5% from 2.9%, while the payout ratio
jumped to 56% from 42%.
“When the market is valuing dividends
above all else, corporate management teams
respond, whether it’s good for their busi
-
ness or not,” says Co-Portfolio Manager
Connor Browne. Investors should consider
not just the willingness, given the market’s
appetite for dividends, but especially the
ability of companies to grow, much less
sustain, their dividend payouts. Thanks
to rock-bottom rates and QE, companies
have sharply increased their debt loads in
recent years, not so much to invest, given
tepid demand. Rather, they’ve engaged in
financial engineering to boost their share
prices by buying back stock and to pay out
dividends.
As the financial media have been point
-
ing out, S&P 500 Index earnings declined
3.2% in the second quarter, marking the
fifth consecutive quarter of declines and
the worst such five-quarter period since the
financial crisis. Earnings are on track to fall
another 2% in the July-through-September
quarter, according to FactSet. Browne
points out that the declines have largely
been the result of the collapse in ener
-
gy-sector earnings, though financial sector
and, as noted, telecommunications earn
-
ings are also expected to decline this year.
Excluding the energy sector, third-quar
-
ter earnings in the rest of the S&P 500
Figure 5
|
How Long Can Sagging Sales and EPS Support a Pumped-Up Multiple?
S&P 500 Index
- 8%
- 6%
- 4%
- 2%
0%
2%
4%
6%
8%
10%
16.2
16.4
16.6
16.8
17.0
17.2
17.4
17.6
17.8
18.0
18.2
Q3 2014
Q4 2014
Q1 2015
Q2 2015
Q3 2015
Q4 2015
Q1 2016
Q2 2016
Q3 2016
Trailing P/E (Left)
Sales Growth (Right)
EPS Growth (Right)
EPS and Sales Growth
P/E
Source: FactSet.
The Elevated Risks of Safe Stocks
|
5
Index are slated to grow, but just 1.2%.
(
Figure 5
) Sustainability of growth in div
-
idend payments, as seen with a number of
quite highly leveraged energy pipeline and
exploration and production companies, is
hardly guaranteed.
The growth outlook for the defensive
stocks as a group isn’t much better now,
with many at peak multiples, than it was in
previous years, when they were more rea
-
sonably priced relative both to their history
and earnings. The implication is that either
they grow into those multiples, or their
multiples compress. “Ultimately, there will
be reversion to the mean,” says Greg Dunn,
co-portfolio manager of Thornburg’s
growth strategies.
Another risk that could make it a bumpy
ride back to the mean is the outlook for
interest rates. If U.S. rates go up again near
term, some defensive stocks, such as utili
-
ties, may well trade off, as their risk/reward
propositions could quickly become less
competitive with U.S. Treasuries and high-
grade corporates that are obligated to pay
their bond coupons, not their stock divi
-
dends. Rather than attractive, the yields
on the stocks could look scary if a rate hike
sparks a selloff in their share prices. The
capital losses could be deep, and the time
needed for dividend income to compensate
for them could run very, very long.
Value Investors’ Hard-Earned
Risk-Adjusted Returns
The risk of higher rates facing pricey
defensive stocks may already be present.
A handful of Fed officials since mid-sum
-
mer have made increasingly hawkish noises
about the possibility of a rate hike, per
-
haps even two, in the months ahead. Some
recent firming in U.S. data—jobs, housing,
consumer spending, industrial produc
-
tion—have bolstered the case for mon
-
etary tightening. As a result, the spread
between two-year and 10-year Treasuries
has widened, while cracks have started to
form among defensive equities. In the two
months following the July 8th record low
in the 10-year U.S. Treasury yield, the
S&P 500 Utilities Index fell 4.2%, while
the Telecom Services sub-index shed 3.8%
and Consumer Staples category lost 2.6%.
On the flip side, higher rates would be a
godsend to beleaguered U.S. banking
stocks, which have suffered for years under
the impact of QE and “ZIRP” (zero inter
-
est rate policy) on net interest margins and
ever-rising capital ratio requirements. The
U.S. KBW Bank Index rose more than
12% in the two-month period. (
Figure 6
)
To be sure, the market may well be react
-
ing to both economic and monetary policy
headfakes, which wouldn’t be the first time.
In its forward guidance, the Fed has con
-
sistently overestimated both inflation and
economic growth, and has almost regularly
had to revise down its forecasts in recent
years. Moreover, for every encouraging data
point of late, other indicators suggest the
U.S. is hardly sailing out of the economic
doldrums. Nonresidential private fixed
investment growth was increasingly nega
-
tive over the three quarters through June.
The Institute for Supply Management’s
non-manufacturing index dropped sharply
in August to 51.4, albeit from a relatively
elevated 55.5 in July, while the manufac
-
turing index slipped below 50 to 49.4,
indicating contraction in activity. And if
the U.S. unemployment rate has effectively
met the Fed’s target, the labor participa
-
tion rate is still at nearly a four-decade low,
while average weekly hours worked has
trended down this year and the monthly
percentage increase in average hourly earn
-
ings declined in August from July. Growth
in labor productivity, or output per hour
worked, was down for the third quarter in
a row in April through June.
Short-term Voting vs. Weighing
for the Long-Term
Disaggregating sector performance of
benchmark indices, examining the sources
of return contribution and assessing asso
-
ciated risks are interesting exercises. The
aggregates alone should give passive inves
-
tors pause, particularly in U.S. equity
Figure 6
|
Banking on Rate Hikes? Defensives Losing Interest?
Sector Performance
(7/8/16–9/8/16)
90
95
100
105
110
115
7/8/16
7/15/16
7/22/16
7/29/16
8/5/16
8/12/16
8/19/16
8/26/16
9/2/16
S&P 500 Consumer Staples Index
U.S. KBW Bank Index (USD)
S&P 500 Utilities Index
S&P Telecommunications Services Index
Source: Bloomberg.
6
|
The Elevated Risks of Safe Stocks
markets. If the S&P 500 Index is trading
at 20x trailing earnings, and its histori
-
cal average is 16.4x, sooner or later, either
earnings have to accelerate or a correction
is coming. Moreover, as capitalization
weighting remains the dominant model in
passive investing, it’s inevitably a momen
-
tum trade: the self-reinforcing dynamic
swells valuation multiples, and risks, if
underlying earnings growth isn’t there to
support them.
The intelligent investor, in Graham’s
value-investing tradition, shouldn’t be
exposed to the current levels of risk fac
-
ing passive investors and bond refugees.
But it’s not easy for active investors. Being
underweight stocks that have enjoyed mul
-
tiple expansion thanks to portfolio flows
rather than earnings growth can make
for extra-painful comparisons against a
benchmark. That’s because those stocks
have both appreciated and at the same time
gained weight in the indices, as noted in
the case of the defensive equities of late. Yet
that’s exactly the merit of the value inves
-
tor. “We’d like to buy things that are less
expensive, not more expensive,” says Ben
Kirby, co-portfolio manager of Thornburg’s
Investment Income Builder portfolios, who
notes that on a forward-earnings basis,
U.S. stocks are trading at a 25% premium
to non-U.S. equities, the highest such dif
-
ferential in a decade. “Outside the U.S.,
you’re paying for a depressed multiple on
earnings that are far from peak,” he adds.
That’s not to say bargains can’t be found in
the U.S. For fundamental, relative value
investors, there are certainly attractively
priced U.S. stocks, whether relative to their
history or to their peers. When the inevi
-
table bouts of market volatility come, these
are the stocks that should have less dis
-
tance to re-trace, and for long-term inves
-
tors who have done their homework, that
should provide more comfort amid the tur
-
bulence and more return over time. Why?
Because market volatility can swing share
prices around far more than a business’
fundamentals would imply. As Benjamin
Graham noted, the market in the short run
is a voting machine, but in the long run is a
weighing machine.
n
The Elevated Risks of Safe Stocks
|
7
Important Information
Source data: FactSet, Bloomberg, and Thornburg, unless
otherwise noted.
Investments carry risks, including possible loss of principal.
Additional risks may be associated with investments outside
the United States, especially in emerging markets, including
currency fluctuations, illiquidity, volatility, and political and
economic risks. Investments in small- and mid-capitalization
companies may increase the risk of greater price fluctua
-
tions. Portfolios investing in bonds have the same interest
rate, inflation, and credit risks that are associated with the
underlying bonds. The value of bonds will fluctuate relative
to changes in interest rates, decreasing when interest rates
rise. Investments in the Funds are not FDIC insured, nor are
they bank deposits or guaranteed by a bank or any other
entity.
The views expressed by the portfolio managers reflect their
professional opinions and are subject to change. Under no
circumstances does the information contained within repre
-
sent a recommendation to buy or sell any security.
Dividend Payout Ratio
– The percentage of earnings paid
to shareholders in dividends calculated as yearly dividend
per share over earnings per share.
Earnings per Share (EPS)
– The total earnings divided by
the number of shares outstanding.
Multiple
– A valuation multiple reflects an investment’s
market value relative to some key metric. Price to earnings
ratio (P/E) is a commonly used multiple. It’s calculated
by dividing a stock’s price by the company’s earnings per
share.
The
ISM Non-Manufacturing Index
is a gauge of business
conditions in non-manufacturing industries, based on
measures of employment trends, prices and new orders.
A value over 50 typically indicates expansion among
non-manufacturing components of the economy. Below 50
indicates contraction.
The
MSCI ACWI Consumer Staples Index
includes large-
and mid-cap securities across 46 developed and emerging
markets countries. All securities in the index are classified
in the Consumer Staples sector, as per the Global Industry
Classification Standard.
The
MSCI EAFE Consumer Staples Index
is a free-float
weighted equity index, developed with a base value of 100
as of December 31, 1998. The MSCI EAFE region covers
developing market countries in Europe Australasia and the
Far East.
The
S&P 500 Utilities Index
comprises those companies in
-
cluded in the S&P 500 that are classified as members of the
Global Industry Classification Standard (GICS) utilities sector.
The
S&P 500 Telecommunication Services Index
com
-
prises those companies included in the S&P 500 that are
classified as members of the Global Industry Classification
Standard (GICS) telecommunication services sector.
The
S&P 500 Consumer Staples Index
comprises those
companies included in the S&P 500 that are classified as
members of the Global Industry Classification Standard
(GICS) consumer staples sector.
The
S&P 500 Index
is an unmanaged broad measure of the
U.S. stock market.
The
U.S. KBW Bank Index
is an economic index consisting
of the stocks of 24 banking companies. The KBW Index
is named after Keefe, Bruyette and Woods, a recognized
authority in the banking industry
The performance of any index is not indicative of the per
-
formance of any particular investment. Unless otherwise
noted, index returns reflect the reinvestment of income
dividends and capital gains, if any, but do not reflect fees,
brokerage commissions or other expenses of investing.
Investors may not make direct investments into any index.
Important Information for Investors Outside the U.S.
In the United Kingdom, this communication is issued by
Thornburg Investment Management Ltd. (“TIM Ltd.”) and
approved by Robert Quinn Advisory LLP which is autho
-
rised and regulated by the UK Financial Conduct Authority
(“FCA”). TIM Ltd. is an appointed representative of Robert
Quinn Advisory LLP.
This material constitutes a financial promotion for the
purposes of the Financial Services and Markets Act
2000 (the “Act”) and the handbook of rules and guidance
issued from time to time by the FCA (the “FCA Rules”).
This material is for information purposes only and does
not constitute an offer to subscribe for or purchase any
financial instrument. TIM Ltd. neither provides investment
advice to, nor receives and transmits orders from, persons
to whom this material is communicated nor does it carry
on any other activities with or for such persons that con
-
stitute “MiFID or equivalent third country business” for the
purposes of the FCA Rules. All information provided is not
warranted as to completeness or accuracy and is subject
to change without notice.
This communication and any investment or service to
which this material may relate is exclusively intended for
persons who are Professional Clients or Eligible Coun
-
terparties for the purposes of the FCA Rules and other
persons should not act or rely on it. This communication
is not intended for use by any person or entity in any juris
-
diction or country where such distribution or use would be
contrary to local law or regulation.
8
|
The Elevated Risks of Safe Stocks
Thornburg Securities Corporation, Distributor | 2300 North Ridgetop Road | Santa Fe, New Mexico 87506 | 877.215.1330
9/26/16
TH3736
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The views expressed by the portfolio managers reflect their professional opinions and are subject to change. Under no circumstances does the information contained within represent a recommendation to buy or sell any security. Investments carry risks, including possible loss of principal. Investments carry risks, including possible loss of principal. Portfolios investing in bonds have the same interest rate, inflation, and credit risks that are associated with the underlying bonds. The value of bonds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. Unlike bonds, bond funds have ongoing fees and expenses. Investments in the Funds are not FDIC insured, nor are they bank deposits or guaranteed by a bank or any other entity. Please see our glossary for a definition of terms: http://www.thornburg.com/legal/glossary.aspx Thornburg mutual funds are distributed by Thornburg Securities Corporation. Thornburg Investment Management, Inc. mutual funds are sold through investment professionals including investment advisors, brokerage firms, bank trust departments, trust companies and certain other financial intermediaries. Thornburg Securities Corporation (TSC) does not act as broker of record for investors.
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