FT REPORT – FUND MANAGEMENT: How to play the yield phenomenon

FT REPORT – FUND MANAGEMENT: How to play the yield phenomenon

By Eric Uhlfelder
Published: Apr 21, 2008

Few seasoned investors are going to bet against the current bear market based on a single indicator. But when the dividend yields of the UK’s largest companies recently hit 4.14 per cent, surpassing five-year gilt rates of 3.97 per cent, the smart money may have noted a key inflection point.

Why? Because these yields don’t cross very often – in fact only twice in the last 50 years – and in both instances a strong stock rally followed.

It happened most recently at the end of the first quarter of 2003 when the dividend yield of the FTSE 100 broke north of 4 per cent while five-year gilt yields tumbled toward 3.5 per cent. Soon after,large-cap UK stocks began a rally that took them nearly 80 per cent higher over the next four years. The FTSE All-Share index did even better, surging nearly 90 per cent.

Around the same time in early 2003 the dividend yield of the US Dow Jones Industrial Average intersected five-year Treasury bond rates at 2 per cent. A strong protracted rally followed. Just last month, the two yields again aligned at 2.5 per cent.

Graham Secker, UK strategist at Morgan Stanley, explains that this yield phenomenon could mean one of two things; that markets are expecting dividends, along with earnings, to contract, or that equities are attractively valued relative to government bonds.
Either way, he sees a number of unusually attractive yield plays complemented by potential price appreciation.

The stocks Mr Secker likes, sporting yields north of 4 per cent, include Vodafone, whose current cash flow covers its 4.32 per cent yield by a factor of two. Mr Secker projects 10 per cent dividend growth until 2010. He also likes oil majors. Both BP and Royal Dutch Shell’s dividends are seen as rising by 10 per cent this year and next, supported by strong balance sheets and record-breaking oil prices.

Mr Secker is also keen on Scottish and Southern Energy and National Grid whose dividends are among the most secure in the utility industry. He surmises that solid balance sheets are likely to generate respective dividend increases of 4 and 8 per cent.
Since the beginning of the year Edward Killen, co-portfolio manager of the $238m (£120m, €149m) Pennsylvania-based Berwyn In-come fund, with five-year annualised returns of 7.56 per cent as of the end of March, has been boosting his largely domestic equity holdings from 18 to 21 per cent. “Our fund is biased toward fixed income,” Mr Killen explains, “but there’s increasing number of high quality equities whose current yields and growth potential gives them among the most compelling total return scenarios of any assets”.

During the first quarter of the year, he increased his exposure to JPMorgan Chase from around 75 to nearly 100 basis points. He started buying shares at about $40. In early April, the stock was trading above $46.

While the stock has held up better than most major banks, falling 36 per cent between last year’s peak and this year’s low, Mr Killen feels it has been oversold, especially given its “manageable” subprime exposure. After a markdown of $1.3bn of subprime securities in the fourth quarter, the bank is believed to have only $2.7bn of subprime exposure on its books, before the Bear Stearns takeover.

“When the financial markets eventually regain their footing we expect the industry to consolidate and that leaders like JPMorgan should be very well positioned,” Mr Killen argues. Accordingly, he’s projecting a substantial re-rating of the firm from 8.5 times earnings to 11 or 12. In the meantime, he’s collecting a dividend of around 3.5 per cent, about 100 basis points above what five-year Treasuries are currently paying.

However, a number of managers aren’t convinced the worst is over, fearing that earnings deterioration will continue and that stocks are not as cheap as current price/earnings ratios suggest.

Stephen Russell, who co manages the £284m ($561m, €352m) London-based Ruffer Total Return Fund with five-year annualised returns of more than 10 per cent, agrees that the intersection of yields in 2003 was a strong buy signal. But he thinks things are different today.

He does not believe that dividends are as sustainable now as they were in 2003 when technology, media and telecommunications shares took the brunt of the sell-off. He fears that “interest rate cuts may not deliver the rebound [or even support] for profits that came in 2003”.

With the credit markets broken and few assets left to inflate through low interest rates, Mr Russell thinks that low bond yields could merely be a signal of much lower growth to come, if not declines in profits.

“Where most financials sustained their final 2007 dividends we expect when interim dividends are announced in the summer and early fall, they will likely be cut from last year’s levels,” observes Mr Russell. He feels the industries most vulnerable to cuts are banks, housebuilders and consumer-related companies.

At the same time, if inflation continues to rise, Mr Russell thinks that five-year gilt yields will also pick up, rising well above future FTSE 100 yields. And if gilt yields remain low, he fears this will inform a slowing economy, which does not bode well for corporate growth, profits and stock prices.

However, this concern has not stopped Mr Russell from doing a little bargain hunting. Since the beginning of the year he has bought Vodafone, GlaxoSmithKline, and BT, which now represent 5 per cent of his portfolio. With yields of 4.6, 5, and 7 per cent, respectively, Mr Russell feels these dividends are not only stable, but are likely to expand on the back of earnings growth.

Aldo Roldan, associate manager of BlackRock’s Global Allocation fund, believes the crossing of equity and sovereign yields speaks more of a value trap than opportunity. “Even though interest rates are falling, earnings are just too upbeat for this environment and equity prices are more likely to fall than rise over the near term,” says Mr Roldan.
Accordingly, he suspects dividend yields could rise further and sovereign yields could fall lower as central banks respond to slowing economies and persistent liquidity and credit problems.

“The positive yield differential we are seeing between equities and sovereigns will likely increase before reaching an inflection point when markets begin to rebound,” reckons Mr Roldan.

He believes three telling harbingers for this turnround are a pick up and then stabilisation of downward earnings revisions; moderation of credit spreads and return of more steady, predictable liquidity; and the return of a less steep yield curve.

Morgan Stanley’s Mr Secker has his own reservations about whether stocks are immediately poised to rebound. With the potential for earnings to continue to fall, he acknowledges that it may take several quarters for dividends to do the same.

With banks making up more than a quarter of the FTSE 100’s market capitalisation, the index’s yield advantage over gilts could be short-lived. And given the challenges of today’s financial markets, betting that history repeats itself may require more than just one compelling sign.

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