Investors have been bingeing on richly valued
high-dividend-yielding stocks and other bond-proxy equities for
the past year. We at AB think its time for an
The craving for stability and yield is understandable, given
current macro anxieties and subpar interest rates and
the likely persistence of both. But following the surge in
flows into passive investing vehicles this year, what has been
apparently a safety trade is showing signs of excess. If
sentiment or conditions change, investors who have overindulged
in safe-haven stocks could be in for a nasty case of
We see a better way to get equity upside potential with far
fewer side effects: by actively targeting companies with high,
sustainable profitability and staying sensitive to valuations.
This flexible approach offers more room to maneuver, to seize
opportunities sometimes in unexpected places and
to avoid expensive, vulnerable corners of the market.
The passion for safety is largely being satisfied passively.
Half of the ten top-selling equity exchange-traded funds so far
this year have been high-dividend and
low-volatility funds. Excluding those top ten, ETFs have
Flows, in turn, have fed into returns: The least-volatile
quintile of U.S. stocks is up nearly 10 percent for the 12
months ended June 2016, and the highest-dividend-yielding
stocks have risen 5 percent (see chart 1). Both categories have
rarely performed better, whereas many other traditional return
drivers have rarely performed as badly.
This binge eating has also fattened valuations. Low-beta
stocks are now trading at some of their highest valuations of
the past 25 years, while the multiples of high-quality and
low-valuation stocks remain reasonable versus their history
(see the left-hand graph in chart 2).
The MSCI minimum volatility index, the most commonly used
proxy for low-beta stocks, currently sells near its all-time
high based on current earnings (see the right-hand graph in
chart 2). The index is also heavily clustered in sectors of the
market beloved for their bondlike behavior such as
utilities, telecoms and
REITs which adds unintended interest rate
sensitivity. These stocks are highly correlated to shifts in
These lofty valuations are a consequence of ultralow
interest rates and increased risk aversion. But what if the
environment changes? Indeed, amid talk of an impending U.S.
Federal Reserve rate hike, the safety trade appears to have
lost some appeal. Some could say that as a proxy for safety at
any price, the index is all shield and no sword.
As we see it, by ignoring valuations and excessive sector
concentrations, investors are limiting their future upside
potential or exposing themselves to greater downside risk when
Recall what happened in the summer of 2013: As concerns
mounted that the U.S. Federal Reserve would begin to ease its
bond purchases, bond-proxy stocks took a beating in the
meltdown widely known as the
These are important considerations in an era in which broad
market performance is likely to be more subdued than it has
These issues underscore the advantages of a nimble, active
approach that seeks to gain more in market upturns than it
loses in downturns. Our guiding principle: Target companies
enjoying well-defended competitive advantages that enable them
to maintain high and predictable profitability.
Being able to identify high-quality, shock-resistant
companies isnt enough, though. To tilt the odds even
further to the upside, you also need to determine whether the
market is properly valuing these characteristics.
In our view, the secret to delivering on the outperformance
potential of low-risk equities lies in focusing on the
ingredients of what youre buying: quality, stability and
attractive valuation. As with any balanced diet, being
selective about what you consume is the best way to produce
healthy results that get attention.
Kent Hargis is portfolio manager of strategic core
equities, Chris Marx is portfolio manager of equities, and
Sammy Suzuki is portfolio manager of strategic core equities;
all at AB in New
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