Find the right defensive income

In times of such volatility, high dividend-paying income stocks and global equities funds are expected to be more defensive. However, this was not the case over the first three months of this year. Over the first quarter of 2018, MSCI World High Dividend Yield index fell 6.6 per cent – more than MSCI World index's 4.8 per cent fall. And respective MSCI indices covering the US, UK, Europe ex UK, Japan and emerging markets fell by similar amounts. 

However, during October, MSCI World High Dividend Yield index only fell 2.6 per cent in contrast to MSCI World, which fell 6.3 per cent, so why the difference? 

In bull markets, when low-yielding growth stocks are doing well, defensive funds and the companies in which they invest lag the overall market as investors chase the high returns on offer from the former. But when the overall market is falling, defensive funds and companies should not do as badly – as was the case in October. To try to understand if these assets can again be as defensive as they were last month it is necessary to understand why high-dividend-yield stocks and funds are defensive in times of drawdown, and why they did not work earlier in 2018. 

High-yield stocks tend to fall into two categories: quality stocks, which are stable, cash-generative businesses offering a high dividend; and companies that offer an income but whose share prices are depressed to varying levels, and have similarities with value stocks.

Traditionally, quality stocks provide a defensive element. Their business models are reliable and stable, and as they are cash-generative their dividends are stable, so even in bear markets investors tend to keep hold of them. But these companies are not high growth so they tend to lag the overall market in bull markets.

Lower-quality high-yield or value stocks often tend to outperform during bull markets, for example when miners or banks have good runs. They can also outperform when value-style investing is in favour, which tends to be when economic growth is reaching its peak. Value stocks can have defensive characteristics in a bear market if it has been caused by overvaluations of growth stocks rather than the macroeconomic cycle.

MSCI World High Dividend Yield index is a combination of these two types of stocks.

A different kind of drawdown

The reason why defensive shares and funds held up in October, but not at the start of this year, is because the two sell-offs were caused by fundamentally different things, according to Andrew Herbert, senior investment manager at Thomas Miller Investments.

“The sell-down earlier in the year was initially triggered by macro sentiment,” he says. “But it then became very sentiment-driven rather than because of actual figures. One reading of US wage inflation that was above expectations triggered the sell-off, but afterwards the numbers went back to normal. Investors also quickly became anxious to buy back into the market, and bought into high-growth, low-dividend-yield stocks. It felt like buy the dip drawback. October felt more as though investors were turning against taking risk, selling the rally. People are getting more nervous and it’s now based on numbers. They’re worried about next year and realise we might be at the end of the economic cycle.”

Gerry Fowler, a global market strategist at Aberdeen Standard Investments, adds that the most notable feature of the recent sell-off was the divergence between quality and growth stocks, with the former outperforming the latter. This was driven by the sell-off in high-growth technology stocks, in contrast to the first quarter when these stocks were the ones being bought.

“This is because, compared with the first quarter, interest rates are rising [with more vigour], which is causing concerns that US growth is ending and monetary policy is tight enough," he says. "This is more of a rate hike cycle causing problems [and there are indications that] dividend-paying shares will outperform.”

Mr Fowler’s explanation suggests that as the October sell-off was driven by macroeconomic concerns and investors exiting crowded positions in growth stocks, this is potentially a good environment for value stocks to outperform. But it is not so good for quality stocks.

Was it really quality?

Charts 1 and 2 show how quality and value performed in the two different periods under investigation.

The charts contradict the notion that quality stocks were defensive in October. Quality and defensive stocks outperformed in the first quarter and underperformed in October, despite MSCI World High Dividend Yield index doing the opposite. This is because this index and MSCI World Value index share a correlation of 0.97, where a score of one means they rise and fall perfectly in tandem. A high dividend yield is one of the attributes of a value stock, so this isn’t surprising. But it means it is necessary to determine which type of high-yield stock will prove to have defensive characteristics.

Analysis by Kasim Zafar, a portfolio manager at EQ Investors, shows that while it is expected that high-yield dividend stocks will provide a defence in a wider bear market for equities, it is the lower-quality value stocks that outperform. And this won't necessarily be when bond yields are rising, but rather during recessions.

But Mr Fowler's analysis found that stocks with a high free-cash-flow yield provided defence in October. This is calculated by dividing the free cash flow after tax and interest before dividends by market capitalisation. These types of stocks are typically held by funds such as Lindsell Train Global Equity (IE00BJSPMJ28) run by Michael Lindsell and Nick Train, even though it is not an income fund.

Value income stocks are more likely to be held by funds such as Schroder Global Equity Income (GB00BDD2CM95), run by Nick Kirrage and Simon Alder. Charts 3 and 4 show how these funds fared over the first quarter and October.

In the first quarter of 2018 the strategy implemented by Mr Lindsell and Mr Train was better than that of Mr Kirrage and Mr Alder at Schroders, and they also beat the MSCI World index. In October, both funds underperformed MSCI World index. However, Schroder Global Equity Income's underperformance could be more because of stock selection as MSCI World Value index beat MSCI World index. 

A reason for this may be the valuations of quality stocks – which are supposed to be more defensive, but were not in October. These kinds of quality stocks have outperformed the wider market over the long term, much of which has been the type of bull market that has favoured growth stocks, when quality stocks shouldn't have. MSCI World Quality index returned 126 per cent in the five years preceding 2018, compared with 108 per cent for MSCI World index and 119 per cent for MSCI World Growth index.

This has left them at higher valuations, meaning their defensive nature is in doubt. But Mr Herbert says it safe to assume they would outperform in a bear market and, should the volatility continue, markets will pay less attention to the valuations of quality stocks.

“It becomes less relevant because of the defensive qualities that you’re after," he explains. "In the short term valuations are broadly irrelevant and it’s all about sentiment."

However, Damian Barry, senior investment manager at Seven Investment Management, is cautious of the defensive ability of quality stocks due to their prices.

“We are very cautious on most dividend stocks, especially those in areas that have traditionally been considered quality income, due to their lofty valuations," he says. "There’s no question that defensive dividend-yielding stocks such as consumer stocks have been trading at a premium because of the stability of their earnings and dividends in an uncertain world.

But this is why Mr Zafar expects high-yielding value stocks to be able to provide a better defence than quality names. He says MSCI World index has a long-term forward price/earnings (PE) ratio of 17.1 times, versus 13.7 for MSCI World High Dividend Yield index. The current PE for MSCI World High Dividend Yield index is 12.7 times.

The undervaluation of high-yielding stocks is even more significant in the US market. “The main MSCI US index PE reached expensive levels and retraced significantly this year," says Mr Zafar. "On a forward PE basis, MSCI US High Dividend Yield index reached extremely elevated levels in 2015 and has been retracing to 15 times today, but the main [MSCI US] index reached an extreme 20 times forward earnings only in early 2018. Overall, on valuation grounds, MSCI US High Dividend Yield index is attractive relative to the main index in the US.”

Searching for the defender

Mr Herbert says he will continue backing funds with quality stocks, in particular because of the rising interest rate environment. Quality companies with high dividend cover and defensive businesses will play their part in a portfolio, despite being perceived as overvalued.

“The rising interest rate is going to be more [of a problem] for the lower-quality stocks because all they really have is their dividend, and you’re not sure that’s going to continue given macroeconomic uncertainty," he explains. “If the interest rate goes up, you have to use a higher discount rate for that dividend income. With value stocks, you don’t have an offset in terms of accounting for the quality of the company. So the higher-quality defensive names will do better.”

Mr Fowler agrees because his analysis shows that markets react more to increases of the London interbank offered rate (Libor) than to ones of US Federal Reserve interest rates, and for much of this year Libor has remained stable. However, Libor is now expected to start rising. 

“Since March, Libor has been flat despite two Federal Reserve rate hikes," he says. "Now Libor is rising again, as the spread between the Federal Reserve rate and Libor is normal, so when the Federal Reserve hikes rates, Libor will rise too. That’s one reason why we’re experiencing concerns about rising rates. All of this will feed into demand for quality, and this bias towards safety and a cash flow yield will mean high-quality companies outperform.”

But Mr Zafar is backing value high-dividend-yield stocks on the grounds that value and high-dividend-yield factors are most likely to outperform during recessions. However, he expects this defensive quality will not be apparent until further down the line.

“Incremental increases or decreases in bond yields have little impact on the broad direction of equities," he says. "The cumulative change in the US bond yield has a tipping point where equities start to struggle, and defensive styles like value and high dividend yield will be of strategic importance in portfolios.”

This tipping point is a 2.5 per cent point increase in the yield of US 10-year Treasury bonds from its most recent lowest point. Currently, the yield is only 1.37 percentage points higher.

Defensive income funds 

Analysts remain convinced that high-dividend-yield stocks and funds will provide a defence if the bear market continues, but investors need to decide whether to back funds focused on quality or value stocks.

For exposure to quality stocks, Alex Moore, head of collectives research at Rathbone Investment Management, likes the strategy implemented by the managers of TB Evenlode Global Income (GB00BF1QNC48). Ben Peters and Chris Elliot favour companies with high returns on capital where there is visibility on dividend growth. They focus on defensive areas such as consumer stocks, and exclude industries such as oil, energy and mining which, despite offering strong dividend yields, are more cyclical. This fund only launched in November last year but is based on the strategy that has proved successful with UK equity fund TB Evenlode Income (GB00BD0B7D55). In the year to date, TB Evenlode Global Income is up 4.1 per cent versus 2.7 per cent for MSCI World index, and has a yield of 1.9 per cent.

Troy Trojan Global Income Fund (GB00BD82KQ40) has an objective of capital preservation, so its manager takes a very defensive view. It has been run by James Harries since launch in 2016 and he targets companies similar to the ones TB Evenlode Global Income holds. But he places greater emphasis on companies that shouldn't suffer significant drawdowns, have well-covered dividends and good visibility on future dividends. Mr Moore says in periods of stress this strategy has worked very well, but also means the fund is likely to lag in bull markets. So far in 2018 the fund is up 1.7 per cent and offers a yield of 2.9 per cent.

If you want to invest in a fund that holds value stocks, options include Schroder Global Equity Income, which yields 3.54 per cent. Although Mr Kirrage and Mr Alder only started running the fund earlier this year they have run UK equity fund Schroder Income (GB00BDD2DX75) since 2010. They target stocks that yield more than the market average in sectors such as financials, consumer and miners. In the year to date the fund is down 1.34 per cent, but Mr Kirrage and Mr Alder’s record with Schroder Income is well-established and highly rated.

Fund performance

Source: FE Analyics as at 30/10/2018