Description

It’s that time of the year… time for the banks to try and out compete on who can be more bullish for next year.  I always use this as a reminder to look at longer term, capital market assumptions for different asset classes and the different sub asset classes within global equities.  As part of that, I was digging around on Research Affiliates’ asset allocation tool, https://interactive.researchaffiliates.com/asset-allocation.html#!/?currency=USD&model=ER&scale=LINEAR&terms=REAL , and came across their smart beta tool, https://interactive.researchaffiliates.com/smart-beta#!/strategies .  None of these longer term expected return tools are helpful in the short term but I’ve always found them thought provoking, at least in terms of highlighting markets/regions that might be mispriced and therefore might have an interesting stock or two.  However, digging around on the smart beta tool, I was intrigued to see low volatility stocks as having the lowest, actually negative, forward returns of any of these factors. Using the ETF, SPLV, which follows the S&P low vol index, I’m short this collection of companies.

What is low vol?  Index construction: “… consists of the 100 securities from the S&P 500 Index with the lowest realized (emphasis mine) volatility of the past 12 months.”  It’s rebalanced quarterly.

In the aggregate, it looks like these businesses are retaining ~25% of their earnings and reinvesting them at a 12% ROE, which should give them ~3% growth going forward.  Combined with the 2.6% dividend yield, that gives you a ~5-6% total return, assuming the multiple stays the same. So how does the multiples compare to history? Not well. If you look at some of the largest constituents in the ETF, you’ll see near all-time/all-time highs in multiples despite relatively pedestrian growth rates and modest ROEs. 

Below is Research Affiliates’ expected forward returns by different factor and low vol is at the bottom. 

Looking underneath the hood, below are SPLV’s characteristics (ROE, dividends, multiples, and payout ratios) by sector vs. the S&P 500 and I walk through each point below.

Sectors: Utilities and REITs are the two largest sectors, and overweights, at 22% and 28% of SPLV

Dividends: SPLV pays 2.6%pa vs. 1.9% for the benchmark and this is primarily driven from the higher payout ratios in utilities and REITs.

Multiples here are high on an absolute and relative basis.  SPLV’s PE is 24x vs. the market at 3.76 multiple points lower but it’s probably easier to see this in the top five constituents below, where I looked at the utilities on an EV/EBITDA basis and EV/EBIT for Republic services.

ROEs are >2.5 percentage points below the market and SPLV’s companies are paying out ~3/4 of their earnings in dividends. 

SPLV’s top five holdings: Using Eversource energy, the largest holding, as a microcosm and here’s the valuation (EV/EBITDA) over the last five years:

The second largest name is Republic Services, which shows the same story, on an EV/EBIT basis:

DTE Energy (EV/EBITDA):

Duke Energy (EV/EBITDA):

American Electric Power (EV/EBITDA):

Another way to look at this is phenomenon is through Goldman’s multiple comparison between stable and volatile growth companies, which shows a similar story and their chart from October is below.

Trade:  I think there’s a number of ways to win with this but I’m using SPLV as the short leg of a spread trade, to maintain the same level of net exposure.  I’m less interested in this as an outright short, given we’re not really close to the “max valuation” that these companies could attain, at least not in the context of 50-60x P/E multiples of 2000.    

Risks:

US 10 Year falls below 1% and stays there

60/40 is dead- Bank of America published this idea and if this played out, you could see the fixed income component of balance portfolios replaced with these bond proxies, which would lead to permanently elevated valuations.  In fact, compared to a 2.5% 10 year at 40x “earnings” with fixed nominal payments vs. SPLV at 24x P/E with growing nominal payments, it might not be crazy.

Sector concentration- Four of the top five SPLV companies are utilities and 28% of the overall ETF is utilities.  I split this risk into two parts, the first being continued momentum in this sector and the second being the long term risk of the businesses outperforming.  In the short term, this could continue to be painful given the price the market is willing to pay for these but longer term, the crux of the thesis is that these valuations aren’t sustainable or at least that the forward returns will be poor given the current valuations.  However, because of this shorter term risk, I prefer this short as the short leg of an RV trade rather than as an outright, standalone short.

Catalyst

Trade war resolution

US economic growth

Interest rates increase

Momentum in this portion of the market reverses

Increased renewable requirements provide a headwind for real growth in utility earnings

Increased realized vol within this group of companies leads to forced selling through the index rebalancing