With interest rates looking likely to rise this year, stocks such as Unilever (LON: ULVR) and Diageo (LON: DGE), often referred to as ‘bond proxies,’ have come under pressure recently.
Bond proxies are a particular group of companies across sectors such as consumer staples and utilities, that are able to generate consistent earnings streams and pay predictable dividends. These stocks have been popular investments in recent years with interest rates around the world at record low levels, offering an alternative to bonds.
Yet, with the possibility of higher interest rates in 2018, the dividend yields from bond proxy stocks may become less valuable soon. As a result, many investors have been rotating out of this subset of stocks this year.
Is selling Unilever and Diageo a good idea, then?
Here are the thoughts of top UK portfolio manager Nick Train.
Short term vs long term
Nick Train says that if you’re a short-term trader, then, yes, it probably does make sense to sell consumer staples stocks such as Unilever and Diageo right now.
However, for long-term investors, it’s a different story.
Train says it’s critical to not make the category error of conflating ‘growth companies’ with bond proxies.
He points out that Unilever has compounded its dividends by 8%pa since 1952 – an incredible achievement.
Government bonds simply do not do this.
In other words, a company that can consistently increase its dividend at an inflation-beating rate, should not be compared to a fixed-income security.
Unilever isn’t expensive
Train also points out, in the January update for his UK equity fund, that just because Unilever shares have risen in recent years, does not mean the stock is expensive.
The portfolio manager believes that a P/E of 20x and thus an earnings yield of 5% is an attractive proposition for serious investors. He says that “exceptionally rare” companies that can compound their earnings steadily for decades can justify P/E ratios of 30, 40 or more.
Wake me up when Diageo trades on 45x earnings
Train notes that Warren Buffett and Charlie Munger basically invented ‘quality investing’ as a response to rising and persistent inflation and as protection against rising bond yields. Companies with strong brands have pricing power and can, therefore, perform well in a rising interest-rate environment.
So, just because interest rates are set to rise, doesn’t necessarily mean that it’s game over for high-quality dividend stocks such as Unilever and Diageo. It’s clear that Nick Train won’t be selling his shares in either company anytime soon.
Disclosure: Edward Sheldon, CFA owns shares in Unilever and Diageo.
This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.