The uncertainty and volatility dominating equity markets in recent quarters has led investors to seek shelter in perceived safe haven investments such as defensive sectors of equity markets and high dividend paying stocks. The strong performance of these areas is a direct reflection of investors attempting to avoid ongoing market volatility, which they believe could translate to sustained losses (i.e., capital risk). Importantly, however, investors jumping on the bandwagon late are finding it more and more expensive to get defensive. This begs the question: will protection today lead to disappointment tomorrow? For investors whose primary goal is to capture compelling absolute returns over the long-term, we believe the answer is “yes”.
Today, the risk/reward tradeoff provided by defensive sectors and companies that pay a high dividend is skewed toward the risk side, as many of these companies may be overvalued relative to history and other areas of equity markets. The below chart shows that high dividend paying, low growth companies are currently trading about two standard deviations above their long-term average. Stocks with the highest dividend payout ratios are trading at a roughly 15% premium to the market.
Similarly, the premium investors are paying for exposure to defensive sectors is high today. As an example, valuations in the Utilities sector are stretched in both relative and absolute terms. On a forward price to earnings basis, Utilities are trading nearly 30% above the sector’s long-term average going back to the mid 1980s. Relative to the broader market, Utilities are trading at valuations nearing 50% above the long-term average over the same time period.
Investors are choosing safety today at the expense of returns tomorrow. What’s worse, they may be paying too much for investments expected to provide downside protection. There is complacency in the market and a ubiquitous attitude that if investors stay put in traditionally safe investments, the storm will pass. In our view, this is a particularly dangerous strategy for investors with a long-term time horizon.
When the market environment is challenging, investors often find themselves fighting yesterday’s battle. They remain focused on the past and attempt to position themselves to avoid a problem or consequence that is, in fact, behind them. We believe this to be the case today. Economic, sentiment, and valuation indicators we monitor are signaling a low probability that equity markets could experience a deep and sustained sell-off today as they did in 2008. Volatility remains higher than normal in the current environment, and is justifiably unnerving for investors, but it is also par for the course given the challenges facing broader economic growth. Sentiment continues to fluctuate frequently when macro data surprises the market, or disappoints, and we expect this trend to continue.
While we believe the risk of a dramatic equity market correction to be low today, investors are nonetheless primarily focused on evading a sustained loss of capital. Preoccupied by the fear of losing money, we believe investors fail to recognize that: 1) the areas that they perceive to be “safe” today have become more expensive, and 2) while high dividend/defensive companies may provide appropriate income and stability for some investor types, they may fail to provide sufficient returns for those many investors that require long-term growth.
In our view, the biggest risk facing investors in the current environment is reinvestment rate risk, or the risk of investing assets at low rates of return, thereby failing to achieve adequate total returns over the investment time frame. Slow global economic growth means that most companies will struggle to find avenues for expansion. Certainly, pockets of growth do exist, but they are scarce. This scarcity of growth suggests that investors should be willing to pay a premium to own companies that are growing faster than the economy. Lately this has not been the case. While investor preference for safety and stability pushed the price of protection up, it also pushed the price of growth down. The nearby chart shows that the premium paid for growth today is near levels last experienced during the most recent recession, a period characterized by intense investor fear and uncertainty.
Rather than follow the herd into crowded defensive investments, we believe long-term investors should be focused on identifying and pursuing attractively priced investments relative to fundamentals. Today, those values can be found in businesses that are well-positioned for growth despite the weak economic backdrop. Indeed, this is where our focus and client portfolio positioning resides today.
Not all investors identify absolute returns and long-term capital appreciation as the keys to the success of their investment plan. For many, preservation of capital and modest income generation are the primary objectives. For these investors, safety and stability will always be important factors to consider. Companies that pay attractive dividends, as well as large, mature businesses, may provide the appropriate balance of risk and reward for investors with income-oriented goals, but in the current environment, a selective approach is warranted in our view. However, pursuing income or downside protection at all costs, (i.e., without regard for valuation, financial stability, or other company-specific attributes) which seems to be the trend in recent quarters, could be counterproductive in the long run.
As long as the markets are driven by short-term sentiment, the environment may remain challenging. However, basing investment decisions around shifting sentiment exposes investors to the risk of not being able to meet their long-term financial goals. We don’t know when the momentum-driven environment will ultimately subside, but we firmly believe that fundamental value will drive long-term returns. More specifically, we believe that growth should eventually demand a premium in today’s low growth world. In our view, long-term investors can find attractive investment opportunities within the challenging market environment by extending their time horizon and focusing on industry and company-specific fundamentals (i.e., growth potential).
Unless otherwise noted, figures are based in USD.
1High dividend yield and low growth stocks refer to stocks in both the highest quintile of dividend yield and the lowest quintile of long term earnings growth estimates.
2The Russell 1000® Index (Russell 1000) is an unmanaged index that consists of 1,000 large-capitalization U.S. stocks. The Index returns are based on a market capitalization-weighted average of relative price changes of the component stocks plus dividends whose reinvestments are compounded daily. The Index returns do not reflect any fees or expenses. Index returns provided by FactSet.
3The S&P 500 Total Return Index (S&P 500) is an unmanaged, capitalization-weighted measure of 500 widely held common stocks listed on the New York Stock Exchange, American Stock Exchange, and the Over-the-Counter market. The Index returns assume daily reinvestment of dividends and do not reflect any fees or expenses. Index returns provided by FactSet.
4The Manning & Napier U.S. Core Equity Composite is a weighted average of discretionary separately managed and proprietary mutual fund accounts with a U.S. Core Equity objective. Accounts in this composite must have a market value greater than $500 thousand USD and tenure of at least one month under our management. This composite includes accounts invested in U.S. equity securities and not invested in proprietary mutual funds, which are not available in Canada. The investment objective of accounts in this composite is long-term capital growth through U.S. equity participation. Returns are after brokerage commissions, reinvested income, and advisory fees. Fees and composite minimum are quoted and administered in USD. Past performance does not guarantee future results. Prior to 01/01/2009, proprietary mutual fund accounts with a U.S. Core Equity objective were excluded from the composite. Fees and composite minimum are quoted and administered in USD. To receive our fully compliant Global Investment Performance Standards (GIPS®) presentation, please contact us at info@manning-napier.com or (585) 325-6880.
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