The Dividend Letter: The price you pay for safety
Paying up for safety is one of the biggest trends in financial markets this year. Investors have vigorously bought into low-vol stocks. Understandable perhaps, in uncertain times it may be smarter to preserve rather than grow capital. The trend has been so strong however that it appears to be to some extent of a bubble in these assets. There are certainly better alternatives available.
Low-vol stocks get their name from the fact that their share price is generally less volatile than the broader equity market. Consumer staples, utilities and real estate are prime examples of such companies. Food, electricity and housing are basic needs and thus we expect them not to face big swings in customer demand, even in an economic downturn. In general, companies in these sectors have therefore relatively stable revenue, profit and cash flow, resulting in more muted swings in stock prices. That quality -safety- is highly valued by investors at the moment for two reasons. It is understandable investors are at times willing to pay a premium for a safe bet. That willingness to pay for safety has caused the price to stretch to extreme levels however. For those willing to look beyond the comfort of low-vol, we are convinced the market offers better alternatives.
Price is what you pay, value is what you get
Nestlé is a great example of how much investors are currently willing to pay for an investment they perceive to be low risk. Nestlé is one of the world’s largest producers of beverages and food. They sell almost EUR 87 billion worth of coffee, milk products and water around the globe this year. They will make close to EUR 12 billion in profits in the process. Currently the stock market puts a value of roughly 282 billion on the company. To put that in perspective, for the same amount one can also buy the following list of eight companies: BMW, Ahold, BASF, easyJet, Orange, National Grid, ING and Nokia (from now on, the basket). The aggregate profit of this group of companies is EUR 22 billion, almost double the total profit of Nestlé. Total revenues are almost 4 times higher at a combined EUR 334 billion.*
In our view the basket mentioned above offers more value for money. That is caused by a 30% jump in the stock price of Nestlé over the past twelve months, while the total value of the basket rose by only 2% over the same period. Over the past three years the difference in performance between Nestle and our value basket is 50%, driven by investors buying into safe low-vol stocks. As a result of that, the company value of Nestlé is now 24 times the company’s annual profit. Combined, the basket of the (above mentioned) value companies can be bought for only 12 times the annual profit. For those who value metrics: the price for the value basket is only 1.2 times the book value of the assets and 0.8 times their expected revenue for this year. Nestlé on the other hand, is selling for the equivalent of 5.4 times the reported value of its assets, or 3.3 times the revenue. Finally, the basket of value companies provide a dividend yield of 4.4% versus 2.3% of Nestlé.*
Based on nearly all traditional measures of value, we would expect investors to be putting their money into the eight names mentioned above. Instead, they continue to buy Nestlé. At this point it is probably good to mention that this is in no way a disqualification of Nestlé as a business. It is a solid, well-run company with a great track record. Investors are just grossly overpaying for it.
IS IT REALLY A SAFER BET?
What could explain such a valuation gap? One explanation may be big, disruptive changes expected in the business environment of most of the eight companies. BMW will have to shift to selling mostly electric cars, with disruptors like Tesla breathing down its neck. Orange is a telecom provider, facing huge investments to develop a 5G network. National Grid is a British utility company subject to Britain’s political uncertainty and ING is a bank whose business model is pressured by low interest rates. This is certainly where Nestlé has the advantage. It is unlikely there will be similar disruption in the market for Kit-Kats or bottled water.
But is Nestlé really a safer bet? The basket of eight companies sells anything from high-end cars (BMW) and cheap airline tickets (easyJet) to mobile phone plans (Orange) and yes, even Nestlé’s products (Ahold). The combined business of these eight companies provide better diversification than Nestlé does on its own. They may be more susceptive to the global business cycle and yes, there is a risk of disruption. But in our view their strong valuation discount provides a substantial margin of safety for setbacks. Nestlé looks priced for perfection. And don’t forget they are not immune to trade tariffs or the rise of private labels.
“The willingness to pay for safety has caused the price to stretch to extreme level.”
We feel, the example of Nestlé versus eight more cyclical companies given above is a trend that is visible in the broader market. In our view low-vol stocks are outright expensive. The question is why they are selling at such a premium compared to the rest of the market. Economic developments offer some insight, and to a certain degree justify the low-vol premium. Given the current slowdown in global growth, the US-China trade war and Brexit negotiations, the economic outlook is murky at best. Defensive stocks offer a place to hide for investors looking to preserve rather than grow capital. Next to the cyclical outlook there is a structural issue with low interest rates. A substantial part of the total bond market offers a negative return to investors. In other words, investors are actually paying to store their money safely in bonds. It is triggering some of them to cross over to equity markets, cautiously. Low-vol stocks offer some bond-like qualities such as stable, predictable cash flows. Which is why they are favoured by investors moving from fixed income to equities. There is ample scientific evidence that when interest rates decline, low-vol outperforms. Thus there are two reinforcing factors. Economic uncertainty has triggered a flight to safety from equity investors, while low interest rates are pushing bond investors into more risky investments. It appears the low-vol spectrum is where they meet to inflate prices .
It is understandable investors are willing to pay a price for a safe return, given the current circumstances. In our opinion, their mistake is that they are all piling into the same short list of stocks. Valuations for low-vol have since ballooned beyond reasonable levels. Especially in comparison to the rest of the stock market. We think there are better alternatives out there, offering more diversification, at lower prices.
*Source Bloomberg, KCM. Performance data based on market prices for 11 November 2019. Valuation ratios are based on market prices and consensus expectations as reported in Bloomberg on 11 November 2019.
This document is prepared by the fund managers of Kempen (Lux) European High Dividend Fund and Kempen (Lux) Global High Dividend Fund (‘the Funds’), managed by Kempen Capital Management N.V. The Funds currently hold shares in BMW, Ahold, BASF, easyJet, Orange, National Grid, ING and Nokia and do not hold shares in Nestle. The views expressed in this article may be subject to change at any given time, without prior notice. KCM has no obligation to update the contents of this article. As asset manager KCM may have investments, generally for the benefit of third parties, in financial instruments mentioned in this article and it may at any time decide to execute buy or sell transactions in these financial instruments. This article does not contain investment advice, no investment recommendation, no research, or an invitation to buy or sell any financial instruments, and should not be interpreted as such. This article is based on information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. The views expressed herein are our current views as of the date appearing on this article. This article has been produced independently of the company and the views contained herein are entirely those of KCM.