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Time to ditch yield for quality

Viral Patel
— 1 minute read

With valuations for Australian yield stocks trading at all-time highs, investors should shift focus to ‘quality' stocks, writes T. Rowe Price’s Viral Patel.

Viral Patel

High-yielding stocks in Australia have benefited from accommodative actions set by central banks against a backdrop of low growth and rising volatility.

Businesses have been reluctant to invest for future growth amid the uncertainty, and investors have similarly favoured a more defensive approach, pouring money into lower-volatility and yield-oriented segments of the market, sometimes irrespective of valuations.

Because of this scepticism, some investors have found comfort in being positioned more defensively – a strategy that was highly successful post the financial crisis.

However, while macroeconomic factors do matter to equity returns, so do valuations.

As the economic cycle develops and turns, these high-yielding companies are unlikely to be able to deliver the necessary growth to support higher valuations.

With bond yields now expected to rise from all-time lows, we believe these stocks are now trading at expensive levels.

A focus on ‘quality’ stocks is likely to prove more beneficial as a long-term yield investment since they have the potential to outperform throughout a complete economic cycle.

A sluggish economic environment

The hoarding of defensive, high-yielding stocks in what appears to be expensive valuations has meant that the traditional recycling of capital into more cyclical areas of the market has not happened with any real breadth.

As a result, we believe that the risk associated with yield stocks is now as high as it has ever been and the macroeconomic boost provided by global central bank policies in recent years, which resulted in bond yields falling to extreme lows, appears to be fading.

Even if bond yields do not start rising, they are unlikely to fall much further given that official interest rates are already at, or around, zero in many countries.

Evidence of price pressures is starting to emerge in some global economies.

In the US, for example, we are beginning to see the emergence of supply-side inflationary pressures such as wage inflation amid a reported tightening in the availability of skilled labour.

As the economic recovery gathers momentum and this situation progressively unwinds, we can expect higher inflation and, in turn, the knock-on effect of rising bond yields.

Against this backdrop, it is harder to justify the higher valuations that Australian yield stocks currently command and, given that yield stocks make up nearly half of the Australian equity index, this has the potential to have serious implications for investors focused in this area.

New phase of the economic cycle

By holding on to defensive winners for too long and failing to identify the shift in sentiment driven by the prospect of earnings recovery in the next stage of the cycle, investors may be missing potential opportunities offered by ‘quality’ stocks.

Empirical evidence shows that the best long-term yield stocks are ‘quality’ stocks — those that grow profitably and, hence, their earnings and dividends grow faster than other areas of the market.

This can be demonstrated by comparing the 10-year returns of a basket of quality stocks (JB HiFi, Seek, Super Retail Group and CSL) with a basket of high-yielding stocks (Sydney Airport, Telstra Corp, Transurban Group and Charter Hall Retail) purchased 10 years ago.

Based on this comparison, the capital growth achieved by investing in quality stocks far exceeds that provided by yield stocks, with a compound annual growth rate (CAGR) of 21 per cent per annum compared to just 1 per cent (which does not even offset inflation resulting in no real capital growth for yield stocks).

What is even more striking is the current yield, on the original price, from the quality stocks is also much higher than the yield stocks, namely 17 per cent versus 5 per cent.

When we add to the mix that quality growth stock valuations are much cheaper, the case for investment becomes even more compelling.

Defining quality

Our definition of ‘quality’ starts from the premise that sustainable share price movements follow value creation over time.

With this in mind, we define quality based on the earnings and cash flow growth a company is able to generate and the sustainable changes in return on capital that flow from capital allocation decisions.

We assess quality by determining the attractiveness of an industry to form a view on expected return on capital and the company’s competitive position within the industry to be able to deploy capital and grow.

The company’s management team’s ability to prudently deploy capital as well as create and execute a successful strategy is also very important.

With the empirical evidence indicating that investing in higher-quality stocks helps both absolute and relative returns over the long term, we believe investors should once again be focusing on a ‘quality stock’ investment strategy.

Viral Patel is head of Australian Research at T. Rowe Price.

 

Time to ditch yield for quality
Viral Patel
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