US equity valuations at 40-year low

US equity valuations are at a 40-year low and represent an excellent opportunity for investors in the medium term, according to Jerome Nunan at Aviva Investors.

Client portfolio manager Nunan said the yield on US equities is now higher than that on 10-year treasuries, a phenomenon that has happened only once (in 2009) since 1972.

Speaking at Investment Week’s US Focus 2011 conference in London last week, Nunan said the higher yield for equities signifies either a recession or that they are too cheap and poised for a rebound. He added the S&P 500 was trading on a P/E ratio of just over 12, compared to the long-term average of 16.

“It all suggests a great opportunity for equities on a five to ten-year view,” he said.
Within the equity universe, income stocks should be the favoured option because they provide greater returns with better stability, he said. Nunan said the total return from S&P 500 companies which paid dividends was 8.9% a year annualised over 40 years. Non-paying firms, however, made a paltry 1.9%.

Companies that pay dividends also suffer less price volatility. Nunan showed data from Société Générale, which found globally, dividend payers had a Sharpe ratio of 0.56, while non-payers came in at 0.42. But US companies which pay dividends were the least volatile of all types of corporate with a Sharpe ratio of 0.65. Thus, Nunan said, US dividend payers offer the highest risk-adjusted returns in the world.

Aviva is providing access to this market sector through its recently launched US Equity Income fund. It is an exact copy of a fund managed by River Road, a Kentucky-based asset manager acquired by Aviva in 2010. It aims to yield 150 basis points above the Russell 3000 index and is currently on track to pay out 3.3% this year.

Nunan described River Road’s investment style as “dividend all-cap value.” This involves ascertaining the “absolute” or real value of a stock, and then buying it at a discount to that value.

He added the “all-cap” part of the strategy allowed the fund to access smaller firms, which tend to offer a higher yield than large caps. River Road also started as a small and mid-cap specialist and therefore has proprietary research on which it can draw.

River Road’s sell discipline is as important as its stock selection. If a stock reaches 100% of its absolute value, the fund manager cannot make further purchases. At 110% of absolute value, the fund manager must trim the position, while at 120%, the position must be closed out. A holding will also be slimmed down if it grows over 5% of the portfolio.

Underperformers, or those stocks which “fail to execute”, can be sold too. If a portfolio contains more than 2% in unrealised losses, the fund manager is obliged to make a sale.

For more coverage from our US Focus 2011 event see next week's Investment Week out on Monday. www.unitedstatesfocus.com