Bond proxies for some investors have been flavour of the year as they continue to pile into dividend-paying stocks in the face of ever-lower bond yields.
But for many, the label ‘bond proxy’ is a real bugbear.
These stocks typically comprise consumer staples, those traditionally considered as the providers of safe, predictable returns – such as pharmaceutical, telecommunication, utility and energy companies – with higher yields than the majority of the bond market.
This label is attached to a broad range of businesses and to qualify you either have to be ex-growth, or deliver steady growth that is too boring for the herd to find attractive.
The difference between ex-growth stocks and dull, steady-growth companies is huge, and is simply not given the credit it warrants due to the short-term nature of the market.
What sounds like quite small differences in rates of total shareholder return – dividend yield plus earnings growth – translates into big distinctions in returns across 20 years due to the power of compounding.
There are periods in the investment cycle when flat and high dividend-yielding stocks will perform well – we have just witnessed one such period – but through these cycles the stocks are seen as relatively unattractive.
You are not guaranteed your money back with equities, so for businesses with no earnings growth, a spread over the bond market is reasonable to reflect the higher principal risk. Because the earnings power of the flat yielders do not grow, this makes them more vulnerable to market deratings and reratings.
On the flip side, the reasonable but growing yielders provide a great margin of safety because their earnings bases compound over time, and this compounding is powerful enough to absorb market deratings and reratings, particularly across longer-time periods.
So in this case, your market timing defines your return, what multiple you pay for it and what multiple you sell it for.
The reason this should play an important part in an investment strategy is that if you get a business’s ability to compound across the medium term, there is a much better margin of safety and therefore the likelihood of making absolute money.
Looking ahead, consumer staples and healthcare continue to have reasonable growth and return prospects, but the potential for telecommunications and utilities remains to be seen.
Without growth, the latter two sectors are more vulnerable to a reversal in bond yields.
Nick Davis is manager of the Polar Capital European Income fund
