Bond proxies: time to buy?

stock-market-futuristic

Many industry experts have commented on the fact that so-called 'bond proxies' have sold off after a long period of high demand from cautious investors seeking alternatives to expensive fixed income holdings.

But Canaccord Genuity Wealth Management's deputy chief investment officer Richard Champion says they are likely to continue to be popular in 2017 and now is a good time to buy them.

'Up until the end of the third quarter of 2016, the seemingly inexorable bull market in government bonds had created a parallel trend in certain equities, often called quality stocks, or bond proxies,' he says.

Typically, these are companies that generate strong cash flows and high returns on their invested capital and reinvest these flows back into the business or buy back their own shares.

BOND PROXY POPULARITY WILL CONTINUE

Champion expects bond proxies to resume their run of popularity in 2017, in the face of continuing macro-economic uncertainty over issues such as Brexit and US president-elect Donald Trump's foreign policy.

'After all, the solidity, high returns and strong cash flows of these companies are convincing reasons to own them for the longer term. The bond proxies are down, but certainly not out,' he concludes.

The suitability of quality stocks - sometimes called 'expensive defensives' - for an investor's portfolio will depend on the individual's overall strategy, target returns, time horizon and appetite for risk, whether they pick individual shares themselves or look for a fund which specialises in this area.

Russ Mould, investment director at AJ Bell, explains that quality stocks underperformed badly in the second half of 2016 - a trend that actually began around the time of the UK's Brexit vote and then accelerated after the US presidential election.

In crude terms, Trump's plans to cut regulation, slash taxes and increase infrastructure spending have been seen as being good for growth - and if growth is going to be stronger, there is less need to pay up for 'expensive defensive' sectors like consumer staples, utilities and telecoms.

But Trump's plans are far from fleshed out, let alone approved by Congress or implemented.

Mould points out that Japan, for instance, has had many false starts since its 1989 stock market peak, which show that disappointment with such spending plans can set in quickly, especially when huge existing government debts are still clogging up the system.

Anyone who does not believe the Trump-led growth story, or who feels that the powerful deflationary forces posed by excess debt, unhelpful demographics, a rising dollar and even the internet will prove too strong, is likely still to warm to the quality growth names, says Mould, especially if they can afford to buy on the current dip, sit out short-term underperformance and take a long-term view.

STOCKS TO WATCH

An example for a bond proxy according to Canaccord is AB Inbev, the world's largest brewer - it has made some big acquisitions and generates prodigious cash flow, and even when it borrows money, it pays it back quickly.

Two stocks which should be on the radar of quality hunters are water utility Severn Trent and luxury fashion brand Burberry, according to Mould.

In addition, Severn Trent comes with a 3.7 per cent prospective dividend yield, potential for profit upside if the planned Dee Valley acquisition goes through, and scope for a friendlier regulatory environment from 2020 onwards as competition is introduced into the UK water market.

Burberry is looking to bounce back from a tough couple of years when Chinese demand slowed and boss Christopher Bailey found himself overstretched trying to do the jobs of chief executive and chief creative at the same time. Marco Gobbetti has now been appointed as chief executive.

'Luxury goods brands can have great pricing power and loyal customer bases, and the weaker pound may tempt a major industry player to come shopping for the whole of the company and not just its leading leather goods, clothes and accessories,' adds Mould.

ACTIVE FUNDS TO WATCH

A number of funds focus on this kind of company, in search of steady long-term returns via both capital growth and income.

Lindsell Train UK Equity targets domestic stocks while Lindsell Train Global Equity has a broader brief (it is best to look at the fund rather than the equivalent investment trust here, as the latter comes at a huge premium to net asset value).

Terry Smith's Fundsmith Equity has built a terrific track record over the last five years, and also has a global brief - around two thirds of its assets are currently parked in US-listed stocks.

Other known fans of quality, and ones that have a specific regional brief, include Alex Darwall's Jupiter European (which also has an equivalent investment trust, Jupiter European Opportunities), Threadneedle European Select and Aberdeen Asia Pacific.

PASSIVE FUNDS TO WATCH

On the passive side two names to watch are the SPDR Global Dividend Aristocrats and SPDR UK Dividend Aristocrats exchange traded funds (ETFs), according to Mould.

The two ETFs select and track baskets of UK-listed and global stocks that not only offer a decent yield but have a 10-year track record of growing their dividends.

Mould says history suggests that it is dividend growth which drives capital returns to the greatest effect.

The five biggest holdings in the UK Dividend Aristocrats ETF are G4S, GlaxoSmithKline, SSE, Pearson and Carillion.

The top five in the global version are American oil refiner HollyFrontier, French mailroom equipment maker Neopost, US printer RR Donnelly and then the UK's Morrisons and Centrica.


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