Warren Buffett thinks there isn't much good value out there right now. "We're having a hard time finding things to buy," said the world's greatest stock picker the other day. The four-and-a-half year long bull market fuelled by cheap money has pumped up valuations in many parts of the equity market. Higher-yielding stocks, for example, have been snapped up by investors seeking income in a zero interest rate world.
The benefits of buying shares with a high dividend yield are well known. Over time, the lion's share of total returns from equities comes from reinvesting the dividends received. Higher-yielding shares can often deliver better price performance too, giving investors the best of both worlds. Nowadays, it’s easier than ever to buy into the best high-yielding shares without having to make any subjective decisions or rely on a manager to do so.
One of my favourite ways of getting exposure to high-quality shares with a good dividend is through Societe Generale's Quality Income (QI) index. The QI index is made up of shares that pay a good and likely-to-be-sustained dividend. Not only does QI focus on companies that make substantial payouts to shareholders, but specifically upon those that are financially robust. As well as a scientifically-selected collection of solid, high-yielding shares, QI offers good diversification. The global index covers companies from Europe, North America, Africa & the Middle East, and Asia, with particularly substantial weightings right now in US, UK and Australian issues. Among its most recognisable individual members are British American Tobacco, Roche and Lockheed Martin.
How QI compares with the MSCI World Index
| QI | MSCI World | |
|---|---|---|
| Annualised total return (%) | 11.5 | 6 |
| Best calendar return (%) | 57.5 | 46.8 |
| Outperfomance (% years) | 52.2 | 47.8 |
| Outperfomance (% months) | 58.5 | 41.5 |
| Worst underperforming streak (years) | 4 | 3 |
| Volatility (%) | 11.9 | 15.6 |
| Maximum drawdown (%) | -33 | -54.1 |
Quality Income's winning ways
QI's record is impressive. An investment of €100 ($84) in QI in 1989 would have become €1,324 by the end of August 2013, after reinvested dividends. The same €100 invested in the MSCI World Index - which covers developed world stocks - would have become only €401 on the same basis. You might think that such a mighty return was only possible by running greater risks. But you'd be wrong: QI's riskiness - as measured by the downside deviation - was only about seven-tenths of that of the MSCI World index.
Based on this track record, there’s a strong case for making QI a cornerstone of a long-term portfolio, especially if you are of an income-seeking bent. Like any index, however, there are certain times at which it will do especially well or otherwise. So, while the QI index is clearly meant to be bought and held over time, it is quite possible to invest in it for tactical purposes, too.
The status QI
Even if investing in QI isn't your cup of tea, there are good reasons why you might still pay attention to it. That's because the state of QI has important messages about the outlook for equities more generally. When there are lots of opportunities in QI - or very few - it can tell us about the sort of returns which might follow over the next 12 months, which is a typical timeframe for tactical investors.
According to SG’s criteria, some 2.17 per cent of stocks from the available universe met the QI criteria as of the end of August. That's towards the lower end of the historic range of 6.42 per cent to 1.74 per cent. This isn’t good news for equities in general. Based on past relationships, the MSCI World index might deliver a total return of minus 2.6 per cent by August 2014. The chance of a negative return may be almost two-thirds.
It's not especially great news for QI, either. If the future looks anything like history, QI might produce a slightly negative total return over the next year or so. Its chances of doing so may be about 50:50. Of course, this is slightly ahead of what we might expect from developed world equities more widely. But the message at least from this metric is clear: neither QI nor developed world equities are likely primed for great returns.
QI's key metric
Still, the amount of QI opportunities out there is only one indicator. When deciding the near-term outlook for quality income, we need to take other things into account. Valuation is another key consideration.
The most important benchmark here is the dividend yield - unsurprisingly perhaps, since QI is a dividend yield-based approach. The level of the current dividend yield has explained more than one-fifth of subsequent annual returns over time, much more than either the price-earnings or the price-to-book ratios.
As of the end of August, the QI index bore a yield of 4.74 per cent. This level of yield is consistent with total returns over the coming year of 10 per cent. And the chance of a positive return is about 85 per cent. However, today's yield isn’t that impressive compared with that on developed world equities as a whole. The dividend yield of 4.7 per cent is just 1.8 times that of the MSCI World Index.
That may sound like a generous spread in favour of QI. But it's actually somewhat thin compared with previous episodes. Generally speaking, QI has done better than the MSCI World Index when its yield has been at least 2.1 times greater. Today's spread suggests no better than even odds of QI producing a superior total return by August 2014.
Momentum matters
One thing that QI does have it going for it right now from a tactical perspective is momentum. To determine this, I run a simple, objective model that aims to be long during uptrends and miss the worst part of big drops. Since 1989, this approach would have yield 1,391 index points, against 1,224 by buying and holding. Its last signal was a buy signal in July 2009 and it remains firmly in an uptrend, by my definition.
What to do now
QI's superb performance over the last quarter of a century makes it an obvious candidate for a buy-and-hold portfolio. The index is easily investible through the SG Global Quality Income Net Total Return exchange-traded note, a London-listed tracker issued by Lyxor. In a forthcoming report, I’ll be looking at how to combine it with other holdings in order to build an ideal long-term portfolio.
In recent months, QI has struggled somewhat. In the first eight months of 2013, it delivered a total return of 5.2 per cent, against 12.1 per cent for the MSCI World index. Does this relatively poor showing represent a tactical opportunity to buy into QI?
Neither valuation nor the lack of QI opportunities makes an overwhelmingly compelling case for buying SG Global QI over the MSCI World index at this exact moment. That said, it would certainly make a very logical choice if you are fearful of an impending bear market. While developed market stocks as a whole slumped 53.2 per cent during the 2007-09 crisis, QI fell by just 36.1 per cent. And it barely fell at all during the shakeout of 2011.
To hear a brief explanation of QI, you can see me talking with Andrew Lapthorne, one of its creators, at: bit.ly/14CDEbf.
