Global Macro Trends

Brave New World: The Yearning for Yield Across Asset Classes

By Henry H. McVey, December 12, 2011

Demographic trends throughout the world—particularly an aging population across borders—carry noteworthy consequences for investors, not least of which is the pursuit of securities that offer both steady growth and healthy, sustainable yield. What does this mean for equities, credit securities and alternative investments?

Enter our Brave New World.

Download this report in print friendly PDF format (1.7mb).

One of our longest-held macro themes, which we term “Brave New World,” is that there has been a major demographic shift in investor preference—one that would drive individuals and institutions toward investments that could deliver both yield and growth. At prior firms, we have had experience investing in and writing about this strategy for years1, and now we’re back to revisit it, or, as Winston Churchill put it, “hit it again.”

In our analysis here, we frame equity “yield” as a growing dividend yield—not just a high, stable one. And the aspect of growth we address is growth via an improving return on capital, not merely growth acquired at any price.

We introduced our Brave New World thesis circa 2004, and chose that name because we thought investors at the time would have had to be brave in order to shun sporty, high-flying telecom and technology stocks—all in favor of stable growers and payers. Back then, the oncoming boom in real estate investment trusts (REITs) wasn’t fully apparent to us, but we were fortunate to spot the attractiveness of energy infrastructure, tobacco, and global franchises. The results of this search for yield and growth speak for themselves. All told, from January 2004 through November 2011, our strategy’s back-tested average annualized return for yield and growth has been 11.2% versus 4.9% for the S&P 500 over the same period. Meanwhile, annualized volatility has been 14.9% for our strategy compared to 17.1% for the S&P 500 over the same period.

Fast forward to today’s environment of very low yields and a renewed emphasis on return of capital, and now we find ourselves asking a totally different question: has this yield-and-growth story played out fully? Our answer, as we detail below, is an unequivocal no. In fact, despite strong performance in recent years, we are ready to give this story a tremendous, Churchill-inspired “whack” because we actually expect our thesis to hold up and even potentially gain momentum against a backdrop of low rates and more uneven growth that define a Phase III environment.2 At the risk of being neither “subtle nor clever,” we think investors would be wise to appreciate that demographic forces remain extremely supportive of the yearn for yield, even as real yields have turned negative in many parts of the world (Exhibits 1 and 2).

Exhibit 1

Falling Real Yields Have Been a Boon to Our Brave New World Thesis

Data as at December 2, 2011. Source: Bloomberg.

Exhibit 2

We See Demand for Yield and Growth Continuing As Boomers Retire

Data as at May 30, 2011. Source: United Nations World Population Prospects.

Interestingly, in recent weeks, we have been asked if we think it is worth exploring whether Brave New World could be applied to investment options outside of equities, including “spicier” parts of the debt market. As we explain shortly, we think the answer is yes, since post-2008 trauma has created both a default and illiquidity premium in such areas as high-yield and mezzanine debt. These areas might be worth exploring for those who agree with our thesis and may have longer-term investment horizons. We also think that debt in emerging markets fits nicely with our approach for capitalizing on Brave New World.

Looking at the big picture, our Phase III macro worldview has not changed much of late. On the margin, we feel better about what we saw in Asia during our November visit; in particular, we are more inclined than the consensus to believe that inflation will fall faster in China, which has already given the authorities some much needed wiggle room.3 We don’t expect lending to reach 2009 levels, though we do believe monetary policy should turn noticeably more favorable versus its prior restrictive stance.

On the other hand, Europe is struggling mightily under the weight of its sovereign debt load. History shows that there are seldom quick fixes for this kind of headwind, particularly when the exchange-rate mechanism is so inflexible for many players in one economic union. Above all, we still think that Greece’s current trajectory of economic growth is far weaker than consensus expectations, and that it will have a difficult time honoring its financial obligations to the Troika. Within the U.S., our work reassures us of the prospect of real GDP growth hitting 1.5–2.0% in 2012, though our quantitative models suggest that next year’s corporate earnings could be weak (Exhibit 3) and that financial-services earnings expectations appear too lofty (Exhibit 4).

Exhibit 3

Soaring Corporate Profits and a Slow Moving Economy Seems Unsustainable

Data compiled as at 3Q2011. Source: Bloomberg, Factset, S&P.

Exhibit 4

Financial Sector Estimates Remain Under Significant Pressure

Data as at November 16, 2011. Earnings revisions = number of up estimate minus down estimates divided by total number of estimates. Source: Factset, S&P, Thomson Financial.

From an asset-allocation perspective, our framework often encourages us to be overweight public U.S. and Asian equities, equalweight Latin America, and underweight Europe relative to the benchmark. We prefer corporate to government debt in nearly every area of the world except for emerging markets (where we like both). Among real assets, we prefer often to sacrifice liquidity in order to own private investments that can deliver return of capital and return on capital, as opposed to highly inefficient commodity notes and indexes that many investors are now pursuing. We still think the U.S. dollar is likely to appreciate in the near-term versus the British pound and the euro. Finally, among alternative investments, we tend to favor traditional private equity in the U.S., growth capital in Asia, and distressed/special situations in Europe.

Brave New World 2.0

Before we address the various investment opportunities in line with our updated Brave New World thesis, we took some time to ensure our thesis still had relevance. We found that not only was it still relevant—but that in our opinion its importance had actually grown. For starters, we estimate the average dividend yield of equity portfolios for retirees was about 2.8% compared to just 1.5% for pre-retirees in 2007, based on the latest available data (Exhibit 5). Given that in the U.S., a baby-boomer will turn 65 every 9 seconds or so (and, more importantly, that there are almost 75 million people who have yet to do so) 4, we maintain our conviction that demand for Brave New World investment strategies will continue to escalate.

Exhibit 5

Retirees Have a Strong Appetite for Dividend Yield

Data sourced as at December 6, 2011. Dividend yield calculated using dividend income as reported by the IRS Statistics of Income Division and equity holdings as reported by the Federal Reserve Survey of Consumer Finances. Our estimate includes an assumption that roughly half of privately held businesses pay some form of dividend. Source: IRS, Federal Reserve, KKR Global Macro and Aset Allocation estimates.

Exhibit 6

Moderate Dividend Yield Outperforms

Data as at November 30, 2011. Source: S&P, Factset Fundamentals.

Exhibit 7

Moderate Earnings Growth Performs Strongly

Data as at November 30, 2011. Earnings growth = FY2/FY1 earnings growth. Source: Thomson Financial, S&P, Factset.

It’s also worth considering that, despite short- and long-term rates falling steadily during the past decade, two types of return sources have consistently outperformed their peers: moderate (not excessive) dividend yields (Exhibit 6), and solid (but not outsized) growth companies (Exhibit 7). Put another way, investors seem to value the combination of sustainable dividend yield and sustainable earnings growth.

Exhibit 8 shows the hypothetical back-tested performance of our Brave New World screening that we initially developed in 2004 and have used in different incarnations ever since to serve a variety of clients. Though our strategy does involve some proprietary “bells and whistles” in the form of quantitative modeling, our essential philosophy behind it is that companies with moderate and growing dividend yields, reasonable valuations, and healthy capital efficiency represent one of the richest ponds from which to fish out market-beating equity returns.

Exhibit 8

Our Brave New World “Yield and Growth” Hypothetical Back-Test Outperformed the U.S. Market

Data from January 1, 2004 to November 30, 2011. Quarterly rebalanced equal-weighted basket based on the following criteria for the universe of the S&P 500: (1) Current dividend yield between 2-5%, (2) FY2 versus FY 1 earnings growth between 5-15%, (3) Rising trailing 12 months return on equity over the past year, (4) FY2 Price-to-Earnings ratio below sector average, and (5) Rising payout ratio or rising dividends paid or rising gross buybacks. Source: KKR Global Macro and Asset Allocation.5

Another key characteristic of Brave New World is that we believe it screens for much better risk-adjusted profiles than traditional equity indexes. From January 2004 through November 2011, our strategy’s average annualized return for yield and growth was 11.2% versus 4.9% for the S&P 500 over the same period; and annualized volatility was 14.9% for our strategy compared to 17.1% for the S&P 500.

As one would expect, dividend-paying stocks are generally less volatile, even though our portfolio is often much more concentrated in terms of the number of stocks than the overall market. Meanwhile, the typical stock identified through our screenings since 2004 has generally produced significantly higher return on equity than the market, despite consistently trading at lower valuations (see Exhibits 9 and 10 for many of our portfolio’s aggregated characteristics).

Demographics: Where Are We Headed?

Famed astronaut John Glenn once said that “there is still no cure for the common birthday.” Indeed, we’re all getting older, but as macro specialists, we endeavor to figure out what it means for economies and markets when waves of the world’s population inch toward their senior years.

Though they are slow-moving, we believe such demographic shifts as aging are crucial to identifying evolutions in investors’ asset-class preferences. In fact, the aging trends we’re observing—as well as their implications for the global economy—are pretty remarkable. Europe and Japan already face significant demographic headwinds (Exhibit 11). Additionally, the U.S. is on the cusp of a major demographic downshift that in our view is likely to further increase the demand for Brave New World-type investments. One must also consider that even in China, which boasts the world’s largest national population, the average citizen will be older than her U.S. peer by 2030 (Exhibit 12).

Exhibit 11

Rapidly Aging Populations are Global in Nature

Data as at May 31, 2011. Source: United Nations World Population Prospects.

Exhibit 12

By 2030, China’s Population Will Be Older Than The U.S.

Data as at May 31, 2011. Source: United Nations World Population Prospects.

There’s another force at work here too, we’d suggest. Exhibits 13 and 14 illustrate that workers just aren’t confident they’ll have enough money to retire, so they are postponing their retirement and trying to find more income-producing investments that would allow them to maintain their standard of living. We believe a similar change in mindset is now afoot outside the U.S., including in Europe.

Exhibit 13

Postponing Retirement Is a Sign of the Times

Data as at March 15, 2011. Source: USA Today, Employee Benefit Research Institute and Mathew Greenwald & Associate’s’ Retirement Confidence Surveys.

Exhibit 14

Fear is Also Driving our Brave New World Thesis

Data as at March 15, 2011. Source: Employee Benefit Research Institute Surveys Retirement Survey.

These global demographic trends lead us to several conclusions. First, we see them as secular, not cyclical, and believe they are likely to positively affect valuations of “growth-oriented” yield securities or investments, including real estate, energy infrastructure, and global franchises. Second, a shift toward yield and growth is often exacerbated by falling inflation, which may be good for higher-yielding assets. Our research indicates that there is a direct relationship between labor force growth and inflation, particularly in economies that are deleveraging (Exhibits 15 and 16). Third, because our Brave New World thesis is global in nature and long-tailed in duration, we believe that the absolute magnitude of the above-mentioned demographic tailwinds may still be underestimated by many, including corporate executives whose companies have the right growth profiles and cash-flow generation to satisfy the specific needs of this growing universe of investors. Fourth, for investors managing money against an equity benchmark like the S&P 500, we think that an allocation of at least 10–20% of the portfolio to this strategy makes sense, compared to an average passive weighting of about 6–7% of the S&P 500 that typically screen as Brave New World stocks.

Exhibit 15

Slowing Labor Force Growth Implies Lower Inflation and Lower Bond Yields

Data as at October 31, 2011. Long term inflation and labor force growth represented as 10-yr annualized growth. Source: Bureau of Labor Statistics, U.S. Treasury, Haver.

Exhibit 16

…The Same Holds True for Japan

Data as at September 30, 2011. Long term inflation and labor force growth represented as 10-yr annualized growth. Source: Japan Ministry of Internal Affairs and Communications, Japan Ministry of Finance, International Monetary Fund, Haver.

A Brave New World of Fixed Income Too?

For years we’ve been pondering Brave New World investments largely in equities. However, we have lately spoken with enough private and institutional investors to believe that equity volatility is forcing investors to consider other options—including corporate fixed income—in order to satisfy their large appetite for yield and growth. Given that the annualized volatility of the MSCI All Country World Index (considered a good measure for public stock-market indexes) over the past decade has been 17%, in contrast with a more modest 6% for the JPM Global Bond Aggregate Index, 10% for the JPM EMBI Emerging Market Debt Index, and 11% for the BarCap Global High Yield Index, we can’t fault them for rethinking their options (Exhibit 17). Exacerbating the issue further is that, as Exhibit 18 shows, the return profiles in many public equity instruments have not been even close to justifying the associated volatility.

Exhibit 17

Volatility Characteristics of Fixed Income Have Made It Easier to Hold in a Bumpy Environment

Data from January 1, 2000 thru November 30, 2011 except JPM EMBI which starts January 1, 2003. JPM EMBI = JPMorgan Emerging Market Bond Index, MSCI EM = MSCI Emerging Market Equity Index, MSCI ACWI = MSCI All Country World Index. Source: Bloomberg.

Exhibit 18

…Particularly When the Return Profiles Have Often Been Better Than Public Equities

Data as at October 31, 2011. Long term inflation and labor force growth represented as 10-yr annualized growth. JPM EMBI = JPMorgan Emerging Market Bond Index, MSCI EM = MSCI Emerging Market Equity Index, MSCI AC WI = MSCI All Country World Index. Source: Bureau of Labor Statistics, U.S. Treasury, Haver.

When asked by these same investors for our opinions on fixed-income allocations, we typically responded by explaining our framework for Brave New World. Specifically within fixed income, we expectedly favor opportunities that sport similar characteristics to what we advocate for equities: good (but not unjustifiable) yields and solid (yet not extraordinary) leverage. Equally important, these issuers should have favorable cash-flow trajectories, which may afford them the opportunity to benefit from structural re-ratings of their outlooks. We also continue to scour the market for instances of rising return on capital.

Exhibit 19

Corporate Market Appears To Offer Much Better Yields And Potentially Less Risk

* = KKR Estimated. Data as at November 30, 2011. Source: Factset, KKR.

Exhibit 20

Corporates Have Delevered, Governments Have Relevered

LA = Left Axis; RA = Right Axis; GDP = Gross Domestic Product. Data as at December 31, 2010. Source: IMF World Economic Outlook, Factset, S&P.

These opinions are also consistent with the macro view we laid out for fixed income in Phase III.7 Specifically, continuing volatility in the capital markets has created a bifurcation between: (i) low yields and high ratings on highly leveraged government securities; and (ii) high yields and lower ratings on non-traditional fixed-income instruments. We see the former group securities as overvalued and the latter undervalued, which is precisely what makes us enthused about some of the “spicier” credit opportunities, as previously described, at this point in the cycle. Exhibit 19 illustrates the size of yield differentials and Exhibit 20 the leverage differentials.

At the moment, our corporate debt of choice is mezzanine, though we think bank loans and high-yield debt are also sensible. Why mezzanine? First is because of its risk profile. Our research shows that investors are now acquiring mezzanine paper in several instances at just 4–6 times EBITDA leverage, compared to pre-2008 levels of just 7–8 times, with yields now largely unchanged at around 12% (Exhibit 19). Meanwhile, at 12%, the yield on mezzanine is so high relative to pension and endowment hurdle rates (which are usually linked more closely to government bond rates) that it now provides significant downside protection (i.e., a cushion of 400–500 basis points).8 Third, we get return of capital in the form of coupon payments along the way, which is obviously germane to our Brave New World thesis. Finally, companies by and large are in structurally better shape now than they were pre-2008 (Exhibit 21).

Exhibit 21

Mezzanine Debt Has More of a Buffer Today Than in the Past

Analysis as at November 30, 2011. Source: KKR Global Macro and Asset Allocation Estimates.

Exhibit 22

Emerging Economies Getting Less Indebted, Developed Economies Getting More Indebted

Data as at September 20, 2011. Source: IMF World Economic Outlook.

While “spicy” corporate credits remain at our highest conviction for fixed-income prospects, we also hold that emerging-market sovereign debt (EMD) fits nicely within our Brave New World framework for several reasons. As Exhibits 22 and 23 show, EMD is no longer a highly levered investment. In addition, because of strong cash flow, its default profile seems to be improving as its peers among developed markets are deteriorating. Nearly 60% of emerging market countries are already rated investment-grade, up from just 2% in 1993. By comparison, developed ratings continue to plummet. Just consider that at present only two-thirds of the countries in the Economic and Monetary Union (EMU) of the European Union are still AAA or AA rated, in contrast with more than 95% in 2002.9 A similar credit improving story is playing out in the emerging corporate bond market as well (Exhibit 24).

We think these diverging trends in sovereign credit quality will continue in the quarters and years ahead. As they do, we suspect that the EMD market will not only improve in quality but also expand in size. We also like the local currency angle that emerging-market debt provides, as it gives us another potential way to “win” in the total-return equation.

Exhibit 24

Emerging Market Corporate Default Rates are Now Below Developed Markets

Data as at October 4, 2011. Source: Moody’s, J.P. Morgan.

But with the opportunity to earn hefty returns from moving out on the risk curve, we acknowledge that there are default and liquidity risks for which investors must be compensated. Is it worth moving out on the curve these days? We think so—and here’s why.

As of December 1, 2011, the yield on U.S. 10-year Treasuries, which is often used as a proxy for the so-called “risk-free” rate, is just about 2.1%. By comparison, a B-rated public high-yield bond is currently yielding about 8.5%, while a similar mezzanine credit security is priced at a 12% yield10. A 640-basis-point spread over Treasuries seems high, particularly when one considers that the loss rate11 during the period since 2006—which would include the 2008 downturn—has averaged approximately 3% for the entire high-yield market.12 Bottom line: we currently think there is a premium default rate of roughly 300 basis points built into the high-yield market that is worth arbitraging (Exhibit 25). Moreover, as we mentioned previously, our research shows that leverage is now lower on many high-yields bonds, while the cash-flow characteristics of many these companies are now actually better after the 2008 crisis than before it.

Exhibit 25

Does a 350 Basis Point Liquidity Premium Make Sense in a Zero Real Rate Environment?

* KKR estimated. Data as at November 30, 2011. Source: Bloomberg, KKR.

Beyond an excess default premium, we also think that the illiquidity premium on mezzanine could be viewed as too steep by some investors. Assuming the mezzanine and high-yield securities mentioned earlier come from the same issuer, then the market appears to be expecting an illiquidity premium of 350 basis points for the “private” component of the security. Unless we’re mistaken, that illiquidity premium seems too high when one considers that (i) the two markets often trade in lockstep these days; (ii) the average duration on many mezzanine financings is, according to our research, 3 years (and this excludes cash coupon along the way); (iii) many plan sponsors are only trying to achieve a 7.7% return in total,13 so, in our example, the illiquidity premium is fully half this number; and (iv) investors are getting this premium in our current zero real-rate environment.

The conclusion is that while mezzanine and high-yield debt are not perfect investments, we do believe the risk/return profile of these “spicier” credits is particularly compelling in the bumpy Phase III environment we envision for traditional, developed-market government debt.

Summary

We maintain that the trends we perceive as part of our Brave New World thesis will continue to influence flows across the capital markets, and that demand for yield and growth is being driven by large, structural changes in the global demographic landscape that may intensify in the next 5–10 years. Additionally, as pensions and endowments favor investments with recurring income, which would allow them to meet near-term obligations with greater certainty we believe, there should be a structural upward revaluation of fixed income and equity securities that can meet the burgeoning demand we are forecasting.

From an asset-allocation perspective, we think that yield and growth stocks should represent one of the most significant wagers one could make in a portfolio. It is also our view that emerging-market, high-yield, and mezzanine debt all represent compelling Brave New World opportunities to help best liability hurdle rates, potentially with fewer downside risks and volatility than one might think.

For those investors interested in further exploring the strategy, Exhibit 26 lists our latest Brave New World screening of equities within the S&P 500.