Analysis: Stock investors take to bond analysis on uncertainty

NEW YORK Fri Sep 3, 2010 10:41am EDT

NEW YORK (Reuters) - Investors are approaching U.S. stock investments with greater caution, and as concerns about the strength of the economic recovery continue some are finding that approaching a stock like a bond may be the best approach.

Bond investors typically take a different approach to valuing companies than stock investors, as they prize strong cash flows and reliable income streams over opportunities for growth.

This credit approach is now looking increasingly attractive to stock investors that fear that another dip in the economy will whack growth and share prices.

"Equity investors that we've been talking to recently have stated that they are looking for things that have kind of a bond-like return," said Brian Yelvington, analyst at Knight Libertas in Greenwich, Connecticut. "People have a preference for predictable cash flows at this moment, no matter what the asset class is."

Bond investors typically grade companies based on the strength of their cash flows, the amount of debt they have relative to their earnings, and other measures including the ratio between earnings and the costs of paying interest on their debt.

Companies that are strong in these metrics are viewed as more resilient to any economic downturn. Bonds are also attractive as they provide regular, fixed income in the form of interest payments.

Stock investors, by contrast, typically concentrate on the opportunity for a company to expand earnings, with a strong focus on boosting its share price.

"The bulk of your return in equities is going to be from not a coupon or a dividend but from price appreciation, said Yelvington. "If you don't believe in a recovery you're not buying into that price appreciation theory."

STOCKS UNDERPERFORM CORPORATE BONDS IN 2010

Stocks have underperformed corporate bonds this year as investors seek out more defensive investments

For example, the Standard & Poor's 500 index has fallen 3.1 percent for the year to date, while high grade corporate bonds have returned 10 percent, according to Bank of America Merrill Lynch.

Investors have also withdrawn around $29 billion from U.S. equity funds year-to-date, with the vast majority of the withdrawals coming in the past four months, according to data by the Investment Company Institute.

That compares to around $84 billion in net inflows into investment grade corporate bond funds year-to-date, according to data by LipperFMI.

Peter Andersen, portfolio manager at Congress Asset Management in Boston, uses credit analysis to help select investments the firm makes in the equity market.

"Equity analysts tend to model differently, they project out to the future and look at earnings, price-earnings ratios and things of that nature, whereas a classic fixed income analyst is looking at the here and now," Andersen said.

"That is a tremendously strong lens that focuses you on the current situation of the company," he said. And, "it's a byproduct of most equity analysts not having a clear sense of where the economy is."

Recent trades include taking a long position in ConocoPhillips (COP.N), which is attractive as the company is selling assets, part of which will be used to repay debt, and also pays a dividend of around 4 percent, Andersen said.

The company's stock is also cheap relative to its peer group, he added. ConocoPhillips has a forward price-to-earnings ratio of 9.01, lower than rivals Exxon Mobil, Hess, and Chevron.

Correlation among the performance of stocks may also fall as investors take a closer look at company's balance sheets, and how they will perform if the economy deteriorates.

The CBOE S&P 500 Implied Correlation Index 2011, which is an estimate of the average correlation of stocks in the S&P 500 index, has risen to around 73 from 65 a year ago, though its down from a high of almost 82 on August 25.

"We've noticed a preference by people to really live up to the term hedge fund and go long versus short, and the things they are look at are those bond-like stocks versus stocks that don't have those bond like characteristics," said Knight's Yelvington.

"This could point to the fact that people expect more differentiation, and even if you don't get more differentiation you're picking up higher yielding equities versus non-higher yielding equities," he said.

(Reporting by Karen Brettell;)

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