Bonds have traditionally been a reliable source of low-risk returns. For the moment, central banks have changed that relationship, yet many investors still need predictable, positive returns to meet their financial obligations. What to do? Reluctantly pushed out of bonds, many investors have turned to low-volatility shares as a bond-like substitute. Many perceive these shares to combine bond-like stability with higher yields and the potential for capital appreciation.
The appeal is understandable. Next to bonds, these bond proxies look great. At the end of October, 10-year U.S. treasuries offered a paltry 1.8 per cent per year, while the MSCI World Minimum Volatility Index yielded 2.8 per cent. Low-volatility shares have also stacked up well against other equities, outperforming the broader MSCI World Index by 25 per cent from the beginning of 2014 through June 2016. Despite that good run, their headline valuations are in line with the broader market as both trade at about 21 times earnings. What’s not to like?
Here’s the concern: If you view risk as the chance of losing money — rather than price volatility — what matters is not the twitchiness of a stock’s price but the relationship between its price and fundamentals. And when investors are trying to figure out how much to pay, they must look past headline numbers. When we do that for low-volatility shares, their fundamentals look stretched and their valuations look less compelling.
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Low-volatility strategies favour defensive sectors such as utilities, consumer staples and telecommunications. As examples, let’s consider a representative from each sector: the American gas and electric utility firm Southern Co., household goods maker Procter and Gamble Inc. and telecommunications giant Verizon Communications Inc. The table below compares the stocks against the MSCI World Index and Nissan Motor Company Ltd., an example of a stock that may be a considerably safer long-term investment despite higher price volatility.
Bond proxies are prized for their dividend yields, but comparing them to their earnings yields shows the driver of the higher dividends is higher payout ratios. That means the companies are devoting more of their earnings to paying out dividends, which reduces the profits available to reinvest in the business. That may not be sustainable.
Nor is earnings growth likely sustainable without revenue growth, but these three bond proxies have experienced that as well. Their sales have declined and more sharply than those of the stock market as a whole. Yet their earnings have been more resilient, which suggests their profit margins have expanded relative to those of the average company. Higher margins can provide short-term support to profits but they can’t rise indefinitely. Eventually, if you can’t grow revenues, you can’t grow earnings.
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Finally, low-volatility shares also look less solid on a cash-flow basis as free cash-flow yields for the three stable shares are all below that of the world index. That raises questions about both the quality of earnings and the sustainability of higher dividends.
These points put the low-volatility shares’ headline numbers in context. Knowing that high payouts are propping up a dividend makes a high dividend yield less attractive. And knowing that earnings are poorly supported by revenue growth and cash flow makes an average price/earnings multiple look expensive. If bond proxy companies are unable to maintain their appealing headline metrics or if higher bond yields make investors less dependent on low-volatility stocks for stable income, valuations could deflate, leaving investors with a rude reminder that even bond-like equities carry equity risks.
The good news is there may be better long-term investment options out there, but rather than paying up to avoid volatility, investors must be willing to accept it.
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Consider Nissan Motor. Its stock price has been more than twice as volatile as global stock markets, it operates in a cyclical industry and its valuation can deviate from its intrinsic value for sometimes painfully long periods. Yet for long-term investors, it may actually have a lower risk of loss than some low-volatility shares. It offers a four per cent dividend yield, in line with that of Southern. But unlike cash-bleeding Southern, Nissan trades at a 14 per cent free cash-flow yield, giving it ample ability to pay higher dividends or reinvest for growth.
Both companies offer better earnings yields than the market, but in Nissan’s case, earnings are supported by increased revenues. Despite fundamentals that appear to be stronger, Nissan trades at roughly half of Southern’s valuation on a price/earnings and price-to-book basis. It’s true that Southern’s share price has been less volatile, but with weaker fundamentals and a more expensive valuation, is the stable share really safer?
Chris Horwood is an investment counselor at Orbis Investments.