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Low-Beta High Dividend Investing Part II

At the end of last year I communicated to you my belief that high-yield low-beta stocks represented a solid opportunity for income generation with historically less risk than other investment vehicles.

Since then, volatility has continued to rise as uncertainty has flowed from all corners of the globe, leaving investors with few strong growth opportunities. Continued domestic issues, festering problems in the Eurozone, and a marked slowdown from the world’s top performers will likely cause this trend to continue for the foreseeable future.

The unique conditions affecting the market today make this type of investment all the more attractive, depending on each individual’s financial resources, investment goals, risk tolerance, investing time horizon, tax situation and other relevant factors.

Domestic Obstacles

The last few months of this year will be a dynamic and profoundly important time in Washington. The way in which the app-roaching issues are eventually resolved will have a major impact on the market.

The first issue to contend with will be the debt ceiling. Since it was established in 1917, the debt ceiling has been raised a total of 75 times – and had become largely a formality[i]. But last summer, lawmakers were almost unable to come to an agreement on the debt ceiling, as a rapidly escalating national debt was becoming a major issue for the country. Republicans were unwilling to commit to tax increases, while Democrats were reluctant to cut entitlement programs. In the end, an agreement was reached with just days to spare. As a result of the apparent lack of political unity and the failure to make a significant debt reduction, Standard and Poor’s downgraded the credit rating of the United States for the first time in the nation’s history.

Current projections show that it will need to be raised again between November 2012 and January 2013; and this time around, there is no reason to believe that it will be any easier. The debt ceiling now stands at an incredible $15.2 Trillion dollars (significantly more than U.S. Gross Domestic product)[ii] and the political environment in Washington has become even more contentious since last summer. Nearly all Republicans in Congress have signed a pledge not to increase taxes at all[iii], while many Democrats have said they will not agree spending cuts without some tax increases.

Several groups have tried to tackle this problem. A bipartisan commission lead by Alan Simpson and Erskine Bowles released a report and recommendations for $4 trillion in deficit reduction that was rejected in 2010. Another bipartisan commission, the “Gang of Six”, made the recommendation that was eventually adopted last summer. This group has been expanded to 12 members, but has yet to release a recommendation for 2012.

At the same time, the United States is rapidly approaching what has come to be referred to as the “fiscal cliff”. Unless congress acts, $1.2 trillion of automatic spending cuts will be initiated on January 1^st. At the same time, the Bush-era tax cuts will expire, raising the burden on the American people while at the same time greatly weakening support mechanisms[iv]. According to the Congressional Budget Office, such an event could lead to a mild recession in 2013[v].

To further complicate matters, the presidential election will take place in November. Many political analysts believe that very little is likely to be accomplished until after the election.

Some in Washington are hopeful for a “Grand Bargain”, which would tackle both the fiscal cliff and the debt ceiling at once. Whatever the outcome, we are unlikely to see a strong rally from stocks as worries about the sustainability of the national debt come to the forefront.

Continued Concerns in Europe

The lingering issues in the Eurozone may also continue to depress global markets. Problems stemming from the sovereign debt crisis have yet to be resolved, and have indeed intensified in the last few months.

Greece has continued to dominate the news this year as measures taken by the European Central Bank, International Monetary fund, and comprehensive fiscal reform have proven incapable of returning the country to solvency. Even after their bondholders agreed to a haircut of 50%, and after receiving 240 billion Euros in loans, the Greek government has been unable to attain the objectives demanded by European leaders in exchange for their aid. The Greek economy, as a result of massive spending cuts, increased taxes, and reluctance of foreign investors shrank by a shocking 6.2% in the first three months of 2012[vi].

This is a problem that does not seem to be going away anytime soon, and the possibility of Greece being forced to leave the Eurozone seems increasingly probable. Indeed, Angela Merkel recently said “What we have always said is that we want Greece to remain a member of the Eurozone. The precondition for that to succeed is that the future Greek government sticks to the memorandum that was agreed with the International Monetary Fund, European Central Bank and the European Commission.”[vii]

In addition, Spain has recently called for help from the Eurozone, after their government could not by itself meet the needs of its struggling banks. In light of the fact that a recapitalization program could cost as much as 100 billion Euros (9% of their GDP), Spanish debt was downgraded from A to BBB, and borrowing costs skyrocketed. To calm the markets, the country received a substantial bailout from the European Stability Mechanism, the use of which will be supervised by a so-called “troika” of the European Central Bank, the International Monetary Fund, and the European Commission[viii].

Financial stability in the Europe seems to be a long way off, and even the most positive outcomes will require painful reform measures from its member nations.

Sluggish Performance from Hot Economies

Even the world’s strongest economies of late have not escaped the downturn in global markets.

A possible “hard landing” for China is again becoming a topic of conversation amidst concerns that their recent explosive expansion is unsustainable. The People’s Bank of China cut the official borrowing rate and the one year deposit rate in the country by 25 basis points each in June in an effort to counteract rapidly slowing growth in the first half of 2012[ix]. Increases in government expenditures, either directly or through state owned enterprises, have typically been another stimulus tool employed by the Chinese government. However, some analysts are concerned that such remark-ably high levels of spending may lead to overinvestment. Many point to the fact that entire cities built with government funds remain uninhabited. Ordos, a development meant for more than one million people in Northern China, has become the most famous of these “ghost cities”, and the rallying point for those bearish on the country.

Chinese officials are hopeful that recently instated measures will raise growth to the desired level, but continued underperformance in in the West would have a negative impact on the world’s biggest exporter.

Other BRIC nations have also experienced downturns recently. Standard & Poor’s recently announced that India could lose its investment-grade credit rating, citing “…slowing GDP growth and political road-blocks to economic policymaking”[x]. Brazilian GDP growth has also slowed significantly as of late, prompting rate cuts from the government in an effort to reverse this trend[xi].

This fizzling performance from the global drivers of growth is unlikely to end until global economic conditions improve.

 

Conclusion

In my opinion, the unique global economic conditions discussed above will likely provide very limited growth opportunities as well as increased volatility in the market until well into 2013. How can the individual investor deal with these negative prospects? High-yield low-beta stocks may help to mitigate some of this risk while still potentially providing a strong opportunity for income generation - and in my opinion remain the best play available.

Beta is a measure of volatility, and is calculated by comparing the variations in the value of a security or portfolio to variations in the value of the market as a whole. A beta of less than one indicates less volatility than the market, and it follows that a beta of greater than one indicates the opposite. Why is this important? For one simple reason: while cyclical growth stocks have the potential for big gains in the short run, these stocks have historically outperformed their peers in nearly all global equity markets, Treasury markets, corporate bond markets, and futures markets[xii]. I would like to highlight two reasons for this disparity. First, share prices typically do not decline as rapidly during downward swings, and as a result future gains may compound on a greater base; and second, stocks with lower beta values generally do not attract speculators who chase price momentum, which makes them less susceptible to bubbles.

If the focus is on limiting risk, then the natural question is – why not just buy investment-grade fixed income securities, such as U.S. treasuries? If you hold them to maturity, the rate is locked in, and the risk of default on highly-rated bonds is quite low. However, while this is certainly a good way to try to avoid risk, bond yields are at historic lows right now. Nominal yields on “risk-free” bonds are near zero, and real yields (adjusted for projected inflation) are actually negative. Because of this, should yields rise, it may be more difficult to move out of bonds one already owns, as the availability of a greater “risk-free” return will put negative pressure on the price of existing bonds. In this case we have seen, perhaps, the opposite of irrational exuberance – extreme risk avoidance.

With many of our clients, we recommend stocks that have higher yields than bonds, and also have the potential for share price appreciation. The current depressed state of equities may also provide a unique opportunity: dividends are determined by income generated per share, and are issued independent of share price - so when prices are low, yields as a percentage are higher.

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