Investor sentiment was crushed during the financial crisis and, after avoiding equities entirely, investors were forced back into equities by the lack of income in bonds. Focus was unsurprisingly on the most bond-like opportunities in the equity market: well-known, defensive income stocks. These stocks now trade at unappealing valuations both relative to the broad market and in absolute terms.
While we do not allocate capital based on forecasts of macro variables such as interest rates, it is clear that rates will continue to rise to more normal levels in 2014 if the global economic recovery persists. Rising rates are a clear headwind for income stocks as income-seeking investors face a choice between income stocks and bonds, and will shift capital to bonds if rates become more appealing.
However, different types of high-yielding stocks behave very differently in a rising interest rate environment. Unlike large-cap, defensive income stocks, cyclical income stocks perform much better in a rising rate environment as they are a less appropriate substitute for a bond and their earnings will see an uplift driven by the cyclical rebound that is pushing interest rates higher.
Value traps may offer ‘value’ in a backward-looking sense, the sustainability of earnings and dividends are in question. Any valuation-driven strategy needs to remain vigilant to value traps, constantly reassessing whether the investment thesis which led us to buy the shares remains valid considering the incremental information that is available.
