At the same time, dividend yields have been rising, as corporate earnings continue to rebound and balance sheets remain healthy and cash-rich.
However, some investors have begun to question whether high-yield stocks have become overvalued following their outperformance in 2011 and increasing media attention. While it is true that high-yield stocks did outperform in 2011, if one digs deeper, you will see that much of this outperformance was driven by a small group of large cap, low-Beta income stocks.
When one breaks up the higher-yielding segment of the global markets into quartiles by Beta, you can see that the most defensive income stocks drove all of the outperformance in 2011 while more cyclical income stocks actually lagged the broad global index.
As a result of this outperformance, more defensive "bond proxy"-type income stocks do appear expensive. Cyclical income stocks, for example, are trading at a roughly 40 per cent price/earnings discount to defensive income stocks, which is the lowest relative valuation for cyclical income stocks since the collapse of Lehman Brothers. While the global economy continues to face obstacles, the environment is clearly better than in the aftermath of the Lehman collapse.
We see this valuation gap as an opportunity for the Lazard Global Equity Income fund, which employs a disciplined, valuation-oriented process to drive capital towards cash-generative, out-of-favour sectors. The portfolio management team’s process has led them recently to reduce mega cap defensive securities in light of the aforementioned valuation gap and rotate capital towards more attractively valued defensive as well as cyclical stocks, where depressed valuations have inflated yields.
However, the team is maintaining the overall balance of cyclical and defensives in the fund and seeking to leverage its broad global opportunity set to find defensive businesses that did not outperform and become richly valued in 2011.
Examples of these include US brewer Molson Coors, Australian baker Goodman Felder, and Darden Restaurants, an operator of casual dining chains such as The Olive Garden in the US.
While Darden Restaurants has been impacted by economic trends, the company’s strong competitive position has enabled it to generate earnings growth over each of the last five years amid a lacklustre economic backdrop.
Additionally, the team is focused on more cyclical companies with solid balance sheets and low payout ratios (where dividends should be resilient even in an adverse macro scenario) where the presence of stock-specific drivers of performance exist.
For example in autos, Valeo is currently benefiting from structural market share gains in higher margin auto parts, while BMW has an enviable competitive position in China, and many of the attributes of a luxury goods company, but trades at a much lower valuation.
In materials, Southern Copper’s valuation seems inconsistent with current copper prices and the company is benefiting from an improving political/regulatory environment in Peru, while Kumba Iron Ore has a roughly 9 per cent yield supported by a net cash balance sheet and low cost production.
While defensive mega cap income stocks outperformed strongly in 2011, thus far in 2012 markets have reversed sharply and more cyclical income stocks have risen strongly while more fully priced defensive income stocks have languished. Markets often reverse course early in the year and in many cases the reversal is short-lived. However, considering the wide gap in relative valuations between cyclical and defensive income stocks, this trend would appear to have strong fundamental underpinnings and could persist.
If so, the Lazard Global Equity Income fund should benefit as its systematic, valuation-driven process allocates capital to companies at the most attractive valuation relative to their financial productivity.
Patrick Ryan is the manager of Lazard Global Equity Income. The views expressed here are his own.