The search for quality yield

Investors have seen sharp increases in the volatility of global share prices in recent times.

The surge in oil prices to record levels, concerns over rising inflation, possible recession and continued weakness in the financials sector has dented investor sentiment.

In these turbulent times, it makes sense for planners to build portfolios for clients around a core of quality, dividend-paying companies that have strong cash flows, conservative debt levels, resilient and stable earnings supported by quality management.

In our view, we are in a lower return environment where quality and sustainable dividends are going to be very important components of total returns, particularly if markets move sideways for a while or continue to decline.

Investors depend on dividends to limit losses during times when economies slow and corporate earnings falter.

In fact, during our recently completed series of GVI adviser briefings around Australia, over 80 per cent of advisers surveyed thought that the income component would play a more important role when shaping clients’ portfolios.

Almost 70 per cent of advisers plan to move asset allocations to reflect a more income-focused and defensive stance given current uncertain market conditions.

Equity markets face two major headwinds that directly impact corporate earnings and profitability.

The recession in the US, slower global growth and rising inflation is an economic headwind that will continue to create uncertainty for equity markets.

The second is the rising cost of credit and reduced access to funding, which signals the end of easy credit and a tougher working environment for businesses.

Recent US data painted a mixed picture for the US economy, although consumer sentiment is still being dragged down by higher fuel and food prices and falling home values.

It seems the US Federal Reserve is shifting its focus from reducing interest rates in an effort to re-inflate the US economy, to growing concerns over inflation, with credit markets now pricing in a potential US rate rise later in the year.

In Europe, the European Central Bank continues to adopt a more austere attitude towards rigorously fighting inflation. It has left the benchmark lending rate at 4 per cent as it grapples with rising inflation fuelled by recent record oil prices.

Financials — no quick fix

The global credit crisis provided another dose of instability as American International Group, the world’s largest insurer, reported greater than expected quarterly losses due to $15 billion in credit-related write-downs. The group also announced plans to raise $12.5 billion in new equity to plug the gap in its balance sheet.

In addition, Standard & Poor’s recently lowered its credit ratings on some of the major Wall Street securities firms including Morgan Stanley, Lehman Brothers and Merrill Lynch, which in effect requires them to post more collateral on the trades with other parties, raising their costs and placing revenues at risk.

Moody’s also announced that it might downgrade monoliners MBIA and Ambac, creating another layer of instability.

These recent events have renewed investor concerns that falling asset values will force financial companies to write-off further credit-market losses going forward as economic activity slows.

Everyone’s trying to pick the bottom in financials, and what the news flow is showing investors is that we’re not there yet.

GVI expects this slow drip-feed of bad news to continue and, as such, is maintaining a defensive position towards financials by holding only a handful of stocks that comprise 9 per cent of the portfolio (index weight is around 22 per cent).

By not being benchmark constrained, GVI does not to hold any US financials in the portfolio, as it has done since inception.

As a result of this turmoil, good old-fashioned bank deposit franchises are back. These companies have greater funding stability provided by a strong retail deposit base with little need to source funding from intransigent wholesale markets.

While the global share markets have rallied strongly over the past three months, we remain very cautious at the moment.

We continue to see volatile markets ahead given continued instability in the financials sector and the impact of rising credit costs on corporate profits.

The conflicting signals of weakening housing markets and soaring commodity prices also makes the world’s central banks’ job of tempering rising inflation while maintaining acceptable levels of economic growth a very difficult one.

GVI remains vigilant and attentive to the opportunities these volatile conditions can present.

It is also important against this backdrop of greater uncertainty in global financial markets to look for and focus on companies that have strong balance sheets, that generate consistent amounts of free cash flow, have good sustainable dividend yields and trade at attractive valuations.

William Tomac is the business manager at Global Value Investors (GVI).