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Safe is getting a lot more risky

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The market continues to march higher. Looking under the hood, however, gives one a more granular view of what areas seem to be leading the charge. Specifically it is the areas of the market that proffer a narrative of safety and income. The safety these areas are offering, however, appears to be getting less so.

The poster child over the last year has been the low volatility and high dividend trade. Take a look at this chart depicting the return of the PowerShares S&P 500 High Dividend Low Volatility Portfolio ETF (red line) versus the S&P 500 Index (green line) year to date. The low-volatility and high-dividend portfolio has soared over 20 per cent while the S&P 500 has marched higher by about 8 per cent.

The largest subgroup of this ETF is the utilities sector. A subsector associated with stable income and low variability in earnings. The utility sector, however, is not offering a significant margin of safety when one considers the multiples that utilities are trading at and even the stretched payout ratio.

This chart, for example, depicts the enterprise value to earnings before interest and depreciation for the MSCI USA Utilities Index. A measure of the company's total value including debt versus a proxy of its cash earnings. You can see it has recently peaked at about 12 times when it historically (over the past ten years) has traded at about nine times — a greater than 30 per cent premium to recent history.

One is now paying a lot more than normal for an ever decreasing yield. The yield is in fact near eight-year lows and the payout ratio is hitting new highs. Both suggest dividend growth may be muted going forward as well. Especially when one notes EBITDA growth is only about 6 per cent per annum for the next couple of years.

There are numerous reasons why this phenomenon has evolved but here are two:

1. Fear of a Correction. It is likely that a segment of investors are still suffering from post-traumatic stress disorder brought about by the last financial crisis. Therefore, they may want to invest but have no desire to suffer extreme bouts of volatility. As a result they would prefer to hide out in the safer more stable areas of the market. The ones that offer lower variability in earnings and price swings. This has likely caused a great deal of flows into these areas which has helped to elevate prices.

2. Reach for Yield. With more and more of the world's bond markets offering paltry or even negative yields, investors have been desperately searching for yield. In many cases, if its pays anything half decent these days investors have clamoured to buy. Thus areas of the market which offer yield have seen increased focus.

The result of these and other factors have driven the “safer” and more stable areas of the equities markets to soar this year and their returns have outstripped many other sectors. However, valuations and even yields have become stretched when one considers various factors. Safe is getting a lot more risky.

Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and the views expressed are his own. Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

The higher ground: High Dividend Low Volatility vs. S&P 500 (Graph source: Bloomberg)
Elevated position: Enterprise Value to EBITDA Ratio of MSCI USA Utilities Index (Graph source: Bloomberg)

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Published August 29, 2016 at 9:00 am (Updated August 29, 2016 at 1:03 am)

Safe is getting a lot more risky

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