Clyde Rossouw (pictured), co-head of Quality and portfolio manager of the Investec Global Franchise Strategy, explains why ‘Quality’ funds should not be considered bond proxies even though they have defensive characteristics.
Quality global franchise companies such as those we look to hold in our portfolios, particularly consumer staples, are frequently referred to as ‘bond proxies’. In turn, the market often assumes that the sector is a proxy for quality. Increased expectations of interest rate rises in 2016 helped trigger consumer staples’ relative underperformance. However, we believe it is a flawed notion that consumer staples and hence quality, perform poorly in an environment of rising rates and steepening yield curves.
The impact of rates on consumer staples varies greatly over time, and the correlation is usually at its highest when rates have bottomed. The much-anticipated inflection point in rates in 2016 meant that the market differentiated less between high- and low-quality consumer staple companies, slashing their multiples across the board. Not all consumer staples are high-quality compounders. Hence, we believe that going forward, variations in multiples across the sector will increase again and good stock picking will remain important.
Not all high-quality compounders are consumer staples
There is little statistical relationship between our funds and long-dated bond securities or levels of the yield curve. In fact, it can even be argued that the correlation of the portfolio is positively skewed to higher bond yields, challenging the notion that these strategies underperform the market in a rising rate environment. There are two main reasons for this. The first is because not all high-quality compounders are consumer staples.
Whilst we continue to find attractive opportunities in the consumer staples sector, over the last few years we have made significant changes to the Global Franchise Strategy’s positioning, with the consumer staples exposure reducing to less than 40% of the portfolio, in favour of interesting defensive growth opportunities, primarily in the technology (more than 25% of the portfolio) and financials (excluding banks) sectors (10% of the portfolio). Secondly, we avoid sectors worst affected by rising bond yields having no exposure to real estate, utilities and telecoms.
Understanding the sensitivity of individual companies to changes in yields – a more important consideration
But one should be careful painting a sector-level brush across Quality strategies and deriving conclusions. We are fundamental, bottom-up quality stock pickers. We believe understanding the sensitivity of our individual companies to changes in yields is a more important consideration. For example, an analysis of the sensitivity of our Investec Global Franchise Strategy on a stock level to changes in US 10-year Treasury yields showed that the relative marginal contribution– the percentage of Global Franchise returns explained by the performance of 10-year US Treasuries – is only 6.4%. This means that 93.6% of Global Franchise returns are actually explained by other factors.
Finally, it is worth bearing in mind that the quality companies we seek to invest in have very little debt. Therefore, they shouldn’t struggle to refinance debt at the higher rates that bond markets are now pricing in. Banks and financials may benefit in the short term from higher rates, but we question how much expectations here are now priced in or even excessive. In the absence of growth, will rising rates lead to loan defaults (both consumer and corporate) longer term?