Stock Watch: Value or growth?

Amid the wreckage of equity markets, it is easy for investors to get excited about bombed-out growth stocks and the potential for recovery in their share price. However, cyclical stocks that have declined in some cases by more than 90 per cent in value may look attractive on paper but could carry hidden dangers. First, while valuation may appear attractive this is contingent on the earnings outlook and future growth potential, which could be subject to downgrades as the recession progresses and economic activity slows further. Second, in a market with tight liquidity and a lack of credit, some growth companies may struggle to finance expansion (either existing or planned). This suggests that although recovery will come eventually, it may be slower than many expect, with the potential for further downside before we start to see a turnaround.

Perhaps more interesting in the near-term are some of the value opportunities that have opened up over the past 12 months. With interest rates at rock bottom and bond yields at historic lows, those companies providing a decent dividend stream with limited potential for further downside risk to their share price are looking increasingly attractive, particularly as many have also been sold off heavily in the market correction. Of course, the challenge here is to identify companies where the dividend stream is relatively secure and valuations appear compelling.

A simple screen looking at those US companies in the S&P 500 index with an indicative dividend yield above what could reasonably considered a sensible long-term risk-free interest rate, 3.5 per cent, throws up 153 potential candidates. If we screen for security of dividend payout by only looking at those companies with enough cash on the balance sheet to cover dividends by a ratio of at least two times, the field narrows to 57 companies. Finally, imposing a valuation overlay (looking at companies whose 12 month forward price-to-earnings ratio is below that forecast for the S&P 500 overall) produces 49 companies to consider, or just less than 10 per cent of the initial universe.

The question then becomes how best to gain exposure to the theme? Is it better to simply invest in a basket containing these 49 companies or should one attempt to stock pick within these names. The decision on what to do most likely depends on your investment philosophy and how much faith you have in quantitative processes. The list of 49 companies is skewed heavily toward three sectors: Consumer Discretionary (10 names), Industrials (9 names) and Utilities (14 names). Moreover, it does not contain any stocks from Healthcare, Information Technology or Telecoms. This suggests that simply buying an equal-weighted basket of the 49 stocks would entail considerable sector-specific risk, and even imposing some sort of sector-weighted overlay would lead to the exclusion of some sectors.

An alternative methodology could be to take the results of initial quantitative screen and then apply a fundamental overlay to it. One approach would be to focus on those defensive sectors that appear to present less downside risk should economic conditions continue to deteriorate. This logically points to investments in areas such as Consumer Staples, Utilities and Healthcare. Since the initial screen did not throw up any Healthcare names, this leaves us with just Staples and Utilities to consider. Within Staples, two of the most interesting names are HJ Heinz Co (HNZ) and ConAgra Foods Inc (CAG). Both offer a dividend yield of above 4.5% with dividend coverage of more than twice the amount of cash on the balance sheet. Heinz trades on around 12 times forward earnings while ConAgra trades on a 10 times multiple. Heinz has lost 19 per cent of its value over the past twelve months while ConAgra has fallen by 26 per cent, both pretty sharp corrections for Consumer Staples companies with relatively stable earnings streams across the economic cycle.

Turning to Utilities, two names of potential interest from the screen are Pepco Holdings (POM) and Centerpoint Energy (CNP). Both are engaged in electricity production and distribution in the US, and again they have been affected by the correction in the equity market over the past year with Pepco down by 36 per cent over the last twelve months and Centerpoint seeing a 21 per cent decline. Pepco offers a 6.1 per cent dividend yield while Centerpoint is yielding 5.7 per cent, with both more than two times covered. Both companies are trading on a multiple of around nine times prospective earnings. Once again, both names look to have been oversold in the stock market correction given their defensive nature and stable earnings outlook.

Summing up, it does seem that those who would like to be positioned for an equity market recovery could do worse than consider value propositions as a hedge against further downside risk. While there are various ways to do this, the approach outlined above using a quantitative screen with a fundamental overlay does produce some interesting names for further evaluation. As with all investing, decisions should not be taken lightly and further due diligence and a discussion with a financial advisor would certainly be warranted before taking the plunge.

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.

 

Gareth-BW

Butterfield Bank’s Gareth Pulman

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