Amit Chokshi
submits:
No middle ground?
January 2010 started off nicely enough before running into a
brick wall once earnings season started in earnest. While 2009 was
characterized by a euphoric rally tied to escaping from the brink,
2010 is likely to be a "show me" year and initial earnings results,
while an improvement relative to comparable quarters, are coming in
below what imputed valuations suggest. This is leading to a quick
rush to the doors as investors attempt to reconcile economic
conditions, company specific issues, and valuations. The period
from 2007-2008 is still branded in investors' minds, so naturally
any slight disappointment is being met with a "take the money and
run" mentality; investors don't seem comfortable waiting for
investment theses to play out. One consequence of the past two
years is that investors have become increasingly nauseous with
equity market volatility and t he recent equity market choppiness
is leading some investors to search for greater safety, which has
in part led to higher inflows in bond funds.
Stretching for yield
In essentially a zero return environment, investors are feeling
squeezed between the nauseous volatility of the equity market and
the near zero-yield of safer fixed income securities. Consequently,
some investors may find themselves stretching for yield and
unknowingly assuming a greater deal of risk relative to the return
they will receive. Extend maturities and investors expose
themselves to the prospect of principal risk if rates rise, while
if one shortens maturities they find that yields are generally
unattractive.
The quest for "safe" but higher yielding assets has driven
investors into corporate bonds including both investment grade and
high yield bonds, but investors may be taking great liberties in
assuming that these are safe or offer an attractive yield relative
to the principal risk. Investors should note that credit spreads
have tightened dramatically since the start of 2009 as the Federal
Reserve was pouring liquidity into the system. Now that the credit
crisis has abated, the Fed has been reining in a number of
quantitative easing programs. While the Fed may not raise rates in
the near term, removing system liquidity could eventually result in
spreads between corporate bonds and Treasuries rising, adversely
impacting current holders of corporate bonds.
More importantly, a number of companies still face the prospect
of refinancing in 2010 and 2011, particularly the most leveraged
ones tied to the leveraged buyout boom from 2005-2007. Given a
tepid economic recovery and removal of Fed liquidity systems, as
these companies come to market to refinance, yields could rise,
particularly in the high-yield bond segment. In addition, while
some of my colleagues that work in structured finance have noted a
rebound in activity, the overall appetite for speculative credit
may be greatly tempered given the decline of CDOs and CLOs.
Investors in corporate bonds are currently paying par or more in
an environment where supportive liquidity systems are being
withdrawn and previous significant buyers such as CDOs and CLOs
have declined, reducing overall market appetite. When combined with
the impending refinancing activity of leveraged loans and high
yield bonds, the cost of credit in this sector may rise, burning
current investors in the corporate bond space.
An easy alternative
So what's an investor to do? I personally think if an investor
can't stand the prospect of drawdowns given the tumultuous two year
period they've experienced, then pure cash and earning 1% on that
is fine rather than extending themselves for yield in securities
that could crack under moderate strains in the credit market.
However, I do believe dividend paying, megacap stocks can be very
attractive for investors that can tolerate volatility and have a
longer-term (2-3 year) view. The biggest hurdle for investors,
however, is to deal with the fact that equities are highly
volatile. The average annual standard deviation of the stock market
is roughly 18%.
This means in a normal distribution and an average annual return
of 5%, 67% of the time returns will range from -13% to 23%. This is
a massive range and once you account for 2-3 standard deviations
from the mean, it's clear how volatile equities can be. Most
investors have been used to the growth experienced from 1982-2000
where volatility was low and despite a rough shake out from
2000-2003, it appeared that things would be fine from 2003-2007.
Unfortunately investors are not in an environment close to what led
to the most powerful bull market period in history (1982-2000) and
market choppiness is much worse now than it was during the raging
bull market of 1982-2000.
At the start of that period the market P/E was roughly 6.0x and
inflation was over 14%. Now we're facing P/Es based on normalized
earnings of roughly 18.0x and investors are faced with deflation.
In 1982, inflation was peaking and P/Es could expand. In today's
environment, rates can't really get any lower and they will
eventually rise, which would punish fixed income investors. While
earnings may be abnormally low due to last year's difficult period,
optimistic forward estimates still indicate that equity markets are
valued at about 15.0x 2010 EPS - not that exciting, particularly in
an economic environment where GDP growth will be unimpressive.
Given the above paragraph, readers may wonder why megacap
equities would make sense. The reason is while the broader market
may be trading in the high teens in terms of EPS, many megacaps are
a bargain, trading for 11.0x-13.0x EPS. In addition, a number of
megacaps offer very healthy dividends. For example, Kraft Foods (
KFT
) offers a compelling bargain considering its strong brands and
presence. Its purchase of Cadbury plc (
CBY
) will expand KFT's product offerings and global reach. More
importantly, KFT offers a yield of 4.2% and an earnings yield over
7%. In addition, KFT basically bottomed out around $21-22 per share
in March 2009 so the downside relative to the current share price
is really not that bad.
In comparison, an investor could be paid 4-6% in near term
corporate grade bonds or 7-8% in long-term corporate grade bonds.
With those bonds, investors are paying par or above par so the only
thing they have to look forward to is clipping the interest
payments. An investor may focus on REITs but the issue there is a
number of REITs are offering distributions not much better than
what KFT would offers, but are trading at higher valuations and
facing significant headwinds in terms of occupancy and refinancing
issues. With KFT and stocks like it, investors have the chance for
legitimate capital appreciation as a case can be made for multiple
expansion, particularly in an environment that may favor consumer
staples. So an investor can experience capital appreciation along
with a very attractive dividend yield. Additionally, KFT has a
liquid options market and investors can manufacture additional
yield through option sales.
If investors encounter an inflationary spike, KFT has the
ability to pass through those increases, which could protect
earnings. In contrast, inflation and commensurate rate hikes would
impair principal values of bonds. The same work can be applied to
other megacaps such as GlaxoSmithKline plc (
GSK
), whose stock is valued at 13.0x and yields 5%. Like KFT, GSK is a
high quality company but has been generally passed over as
investors focused on the high risk trade in 2009 and may now be
trying to figure out where a reasonable place to focus on in 2010
will be.
The general theme with these megacaps is that they trade at
cheap P/Es with earnings yields over 7%, pay hefty dividends (4%+),
and have options markets that can be utilized to generate
additional yield. Cheap P/Es present the prospect for increased
valuations as it's not difficult to make the case for a global
leader to be valued at 15.0x EPS rather than the 12.0x EPS some of
them are currently trading at.
Investors that partner with managers that can identify these
types of opportunities should do well in 2010 as the underlying
businesses of these stocks are generally very strong. Nonetheless,
there are still numerous opportunities in the small and mid cap
arena and specific sectors but these require much more intense
company-specific analysis and valuation exercises along with a
stronger stomach. For example, I am focused on a number of regional
banks but there are still potential landmines in this space and
finding the right opportunities requires a bit more due diligence.
My fund and managed accounts are also invested in Sprint (
S
). On the surface, S is worst in class and embroiled in a nasty
price war but once one digs beneath the surface there's a lot to be
excited about with this company. However, investing in regional
banks or a turnaround like S requires a lot more groundwork and
investors that don't want the stock and business volatility
associated with these smaller companies are much better served with
increased exposure to megacaps with higher yields.
Original
post
(pdf)
Disclosure: Author manages hedge funds and managed
accounts long KFT, long S
See also
Another Equity Stampede, Value Notwithstanding
on seekingalpha.com