Wednesday, 3 April 2013

Equities, playing defense - Consumer staples, an embedded free "partial crash" put option

"Defense is a definite part of the game, and a great part of defense is learning to play it without fouling." - John Wooden, American coach

In continuation to previous conversations discussing the relationship between equity versus credit we would like to point out the downward protection offered by Consumer Staples and its recent relationship with High Yield since the financial crisis of 2008/2009. We will also look at the "greatest anomaly" namely that you get superior long term returns from low volatility equities.

As indicated by a very interesting note from Societe Generale from the 26th of March from their Global Quantitative Research team entitled - Consumer Staples outperformance solely attributable to market crash protection where they indicated the following relationship with the high yield bond market:

"Over recent years, the Global Consumer Staple sector has performed more in line with the high yield bond market than the broader equity market – or indeed, the MSCI high dividend yield index. This market-beating performance has been attributed to the clamor for quality yield but we’re not convinced. Here we show that the outperformance was wholly driven, not by yield, but the ability to limit losses during periods of acute market weakness. Essentially, fund managers are not seeking yield but buying downside protection, and in a world where market shocks are more common, the resulting premium is perfectly understandable." - source Societe Generale

Consumer Staples, or how to play defense when capital preservation dominates performance:

"The chart below plots the performance of the Global Consumer Staples sector versus high yield bonds, high yield equity and the overall global equity market. As the chart shows, in recent years, whilst ‘high dividend yield’ has largely tracked the equity market, the Consumer Staples sector has more closely mirrored the high yield bond market. Not only are total returns similar, but drawdown (peak to trough losses) have also been around 35%." source Societe Generale

"From the chart above it seems that the outperformance of high yield bonds and the Consumer Staples sector has been fairly consistent, but the relative performance versus MSCI World reveals that the bulk of outperformance came during the financial crisis of 2008/09 and the Eurozone crisis in the summer of 2011." -  source Societe Generale
"Capital preservation is a concept that many investors understand but perhaps underestimateNo doubt this is because major market declines tend to happen suddenly and on a relatively infrequent basis. This is also why market bears – as we know from experience – tend to look completely stupid most of the time. To demonstrate the importance of loss avoidance, we have taken the often quoted Consumer Staples sector as our example and we aim to demonstrate that the premium afforded to this sector and its outperformance in recent years is courtesy of downside protection." - source Societe Generale

On another note, Gary Shilling in a Bloomberg column on the 30th of January entitled - Where to Invest While Markets Remain "Risk On" also seems to favor Consumer Staples as part of an overall investment strategy:

"Consumer Staples and Food:
Items such as laundry detergent, bread and toothpaste are essentials that are purchased in good times and bad. Their producers’ equities will remain attractive. The Standard &Poor’s Consumer Staples Sector Index was up 10.8 percent last year, after a 14 percent gain in 2011. Among retailers of consumer staples, the winners may continue to be discounters, such as Family Dollar Stores Inc. U.S. used-merchandise stores have been thriving. Producers of national brands will need to continue to adapt to weak consumer incomes and high unemployment by emphasizing cheaper “value” products."

But moving back to the downside protection offered by Consumer Staples, Societe General offers some an interesting analysis on the downside premium offered by this sector:

"Firstly, we devise a strategy that invests mainly in Consumer Staples but we switch into the equity market rather than the staying in the sector during periods of major market declines. By doing this we effectively remove the drawdown protection from the sector by being totally invested in equities instead of lower-beta Consumer Staples during market pullbacks. 
So, with perfect foresight, we identify the months when the MSCI World index lost more than 3%. Then, rather than stay invested in Consumer Staples (as you should), we invested (mistakenly) in the equity market instead. The purpose here is to understand just how important capital preservation is in driving overall returns from the Consumer Staples sector versus the market by replacing the best months of relative performance with the market return. By investing in the market, and not the sector, during those periods when the market was down 3% or more effectively kills the outperformance of the sector, to the extent that the sector goes from outperforming by nearly 50% to underperforming by 20%. This in part starts to demonstrate just how important the downside protection is in driving the performance of this sector.

If we repeat the exercise but this time for a threshold of -5% or more (which happened 12% of the time), we find that the sector performs in-line with the market. This suggests to us that the value of the put option offered by the Consumer Staples sector protects investors from monthly declines of 5% or more i.e. you can generate market performance and be insulated to a degree from major market shocks." - source Societe Generale

"Let’s explain things a little differently. Imagine a strategy where one invested in the market most of the time but (with perfect foresight) switched into the Consumer Staples sector during months when the market fell by 3% or more. By comparing this strategy to the performance of Consumer Staples sector we can measure the protection being offered and, as we show below, see that this strategy outperforms the Consumer Staples sector, implying that the better performance of the sector is not sufficient to compensate the investor when markets decline by 3% or more. But what happens if we switch to investing in the sector during months when the market fell by 5% or more?

While our strategy invests in the market 88% of the time and in the sector just 12% of the time, its performance almost perfectly matches the overall performance of the Consumer Staples sector. Hence our assertion that the sector is primarily a market index with a put option attached, much in the same way we describe another quality measures such as Merton’s balance sheet model and Piotroski’s F-score." 

Societe Generale concluded their note with the following important point relating to the limitation of the protection offered by Consumer Staples:
"Of course the Consumer Staples sector does not fully protect the investor as it too can fall, but historically by only 60% of the market fall. Valuing our put option is difficult. But with the incidence of months when the market fell by 5% or more being twice as common in the last 15 years than in the previous 25 (see below), this put option has become more important to investors. As we have stated on numerous occasions, understanding drawdown risk and capital preservation qualities is paramount to understanding what an asset is worth. With the events in Cyprus still ringing in our ears, that has never been more relevant than today." - source Societe Generale

The downward protection from Consumer Staples can be illustrated from the following Bloomberg graph highlighting the performance of Consumer Staples versus Consumer Discretionary and Financials since October 2007 until October 2012:

Another way in protecting a portfolio is investing on ETFs such as the PowerShares S&P Low Volatility Portfolio for protection from stock-market swings as indicated by Charles Stein in his Bloomberg article from the 20th of March - ETF Beating Markets With Gains Less Price Swings:

"Investors who bought PowerShares S&P 500 Low Volatility Portfolio for protection from stock-
market swings when it debuted almost two years ago got an unexpected bonus: They also made more money.
The $4.1 billion exchange-traded fund, which owns the 100 stocks in the Standard & Poor’s 500 Index with the lowest volatility, gained 30 percent since its inception on May 5, 2011, compared with 21 percent for the benchmark U.S. index. The ETF, the largest of its kind, achieved that performance with about 70 percent of the volatility in the index, giving it a risk-adjusted return double that of the market, according to the BLOOMBERG RISKLESS RETURN RANKING." - source Bloomberg

Of course, no real surprise looking at the composition of the index detailed in the article and the "defensive theme" of its components:

"In the low-volatility index, utilities represented 31 percent of the portfolio, compared with 3.4 percent in the regular U.S. benchmark, and consumer staples accounted for 24 percent, versus the index’s 11 percent at the end of February, according data from Standard & Poor’s. Information technology, which represents 18 percent of the S&P 500, made up 3.6 percent of the low-volatility portfolio.
Among the biggest individual holdings in the PowerShares ETF are Johnson & Johnson and PepsiCo Inc., the two stocks in the S&P 500 with the lowest volatility over the past year --10.1 and 10.4, respectively. Johnson & Johnson, based in New Brunswick, New Jersey, advanced 21 percent in the 12 months ended March 15, and Purchase, New York-based PepsiCo climbed 18 percent." - source Bloomberg.

In terms of top contributors to the performance, in continuation to our "defensive them" the article indicated Consumer Staples as the top performers:
"The biggest contributor to the ETF’s performance over the past year include H.J. Heinz Co., the Pittsburgh-based ketchup maker being acquired by Warren Buffett’s Berkshire Hathaway Inc. and 3G Capital Inc., portfolio data compiled by Bloomberg show. Hershey Co., the Hershey, Pennsylvania-based candy company, was the second-biggest." - source Bloomberg

We indicated early in our conversation we would look at the "greatest anomaly" namely that low volatility stocks have provided the best long-term returns. In addition to Societe Generale's point on the defensive features of low-volatility stocks such as Consumer Staples, they also provide the best returns as indicated in the same Bloomberg article from Charles Stein:

“The long-term outperformance of low-risk portfolios is perhaps the greatest anomaly in finance,” Harvard Business School Professor Malcolm Baker wrote in a 2011 paper in Financial Analysts Journal.
When S&P designed the low-volatility product, it traced the history of the index back to 1990 in a process known as backtesting. The numbers showed that over three, five years and 10 years, the low-volatility index had a higher total return than the S&P 500.
Harvard’s Baker said market data going back to the 1930s show that low-volatility stocks have delivered about the same returns as market indexes, a result that contradicts the notion that higher risks translate to higher rewards. “In this case you are taking less risk, but not giving up any return,” he said in a telephone interview.

Investor Behavior
Other studies have come to similar conclusions, according to Joel Dickson, a senior investment strategist at Valley Forge, Pennsylvania-based Vanguard Group Inc., who said finance scholars have a hard time explaining the mismatch. Most theories attempting to explain it revolve around investor behavior.
Because people are overly smitten with fast-growing, glamorous companies, they bid up the prices of those stocks to the point where future returns suffer, said Dickson.
Dickson offers a caveat. When stocks soar as they did in the 1990s, low-volatility holdings can underperform for long stretches, said Dickson, a senior investment strategist at Valley Forge, Pennsylvania-based Vanguard Group Inc. “As an investor you have to be willing to stomach periods
when this strategy gets killed,” Dickson said in a telephone interview.
In the nine years ended Dec 31, 1999, a period in which stocks gained 21 percent a year, the S&P 500 Index returned more than twice as much as its low-volatility counterpart, according to data compiled by Bloomberg. It also outperformed after accounting for price swings, with a risk-adjusted return of 32 percent, compared with 20 percent for the low-volatility index." - source Bloomberg

We therefore disagree with Gary Shilling, Consumer Staples are not purely a "Risk-On" strategy given that as indicated by Bloomberg:
"In the nine years ended Dec 31, 1999, a period in which stocks gained 21 percent a year, the S&P 500 Index returned more than twice as much as its low-volatility counterpart, according to data compiled by Bloomberg. It also outperformed after accounting for price swings, with a risk-adjusted return of 32 percent, compared with 20 percent for the low-volatility index." - source Bloomberg

But, Consumer Staples are mostly a defensive play that can outperform during phases of "Risk-Off" which we have been experiencing on numerous occasions since the financial crisis of 2008:

"The low-volatility index did best in times when stocks fell, such as 2000 to 2002, and in 2008, according to S&P data. In 2008 the low-volatility index fell 21 percent compared with 37 percent for the S&P 500." - source Bloomberg.

On a final note, in relation to the differences between equity and as posited by our good friend Paul Buigues, Head of Research at Rcube Global Macro Research in his post "Long-Term Corporate Credit Returns":
"Equity is an infinite claim on the free cash flows generated by a company. Due to the inherent uncertainty of future cash flows, relying on a pure valuation framework to predict equity returns is often a disappointing experience, for both specific companies and equity as an asset class.
Corporate debt, on the other hand, is generally a finite claim on a predetermined stream of cash flows (coupons + principal repayment)."

Corporate credit is a much simpler bet than equity, especially for investors that hold credit instruments until maturity. For instance in High Yield as indicated by our friend Paul "initial spreads explain nearly half of 5yr forward returns" (even for a rolling investor (whose returns are also driven by mark-to-market spread moves)

When it comes to yield the PowerShares ETF has a dividend yield of 2.78 percent compared to 2.13 for the S&P 500 Index, according to data compiled by Bloomberg, so could it be that after all Consumer Staples in  the equity space are a much more simpler bet, in similar fashion to corporate credit? One has to wonder...

"Right is its own defense." - Bertolt Brecht

Stay tuned!

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