Can quality growth stocks continue shooting the lights out?
Investors who have their money in consumer goods giants, either directly or in funds heavily exposed to this area of the stock market, will have made some handsome returns over the past couple of years.
Take Fundsmith Equity, for example, a portfolio that is jam-packed with high-quality businesses. They are typically established firms armed with big brands and intellectual property, which helps set them apart from their current and indeed future competitors.
Fundsmith's school of thought, which is a big attraction for investors in these uncertain times, is that these businesses should be able to sustain a high return on operating capital across all stages of the business cycle.
As David Jane, a multi-asset fund manager at Miton, points out, backing these names has been the place to be over the past five years.
TOP FUND PERFORMERS
Jane looked at 16 of the most popular companies in this area - the likes of Coca Cola, Unilever and Philip Morris - and found that on average each share has delivered close to 10 per cent annual dividend growth.
Share prices have also rocketed, which has helped drive Fundsmith Equity to the top of the Investment Association's global sector performance tables. Over five years the fund is up 168 per cent. The average fund in the sector has returned 73 per cent over the same timeframe.
Other funds that specialise in these quality growth names have also been shining. Finsbury Growth & Income trust, managed by Nick Train, has seen a 135 per cent increase in both the share price and the net asset value over the past five years.
One of the drivers behind their stellar performance has been the fact that the consumer goods giants have been high in demand, with a flood of money coming from more conservative investors hunting for reliable income sources. In a normal environment this type of investor would stick to bonds.
But given the lack of yield on offer, a consequence of the fact that bond prices have been pushed up to unprecedented levels by central bankers' monetary policy, investors have been pushed towards equities and have naturally turned to what they perceive to be safe and reliable dividend payers - so-called 'bond proxies'.
On the back of their good run these shares have become more and more expensive, while their dividend yields have become less attractive.
THE FUTURE OF DIVIDEND GROWTH
According to Jane the average dividend yield was 3 per cent for the 16 companies he looked at. Jane's view, which is shared by many others, is that the golden era for bond proxies is coming towards its end.
He notes these businesses cannot continue 'squeezing the lemon forever' - producing high single-digit dividend growth year in, year out.
'Growth in the future must come from top-line growth or increasing debt burden. Simply borrowing money to pay dividends should not be seen as a value-adding strategy,' says Jane.
'We doubt we will ever sell out of these areas completely as the absolute attractiveness of a slow-growing 3 per cent yield makes sense in the long run, but as total return investors we have to accept that dramatic outperformance of this area versus other equities cannot persist forever.'
James Clunie, manager of the Jupiter Absolute Return fund, is betting against bond proxies. Without naming names, he said he is 'shorting' a number of high-quality consumer goods stocks. According to Clunie the expectations (in terms of earnings growth) implied into their share prices is too high.
'These businesses are so heavily valued that it would be probably be a long-term mistake to buy today,' says Clunie. 'The stocks may have safe cash flows, but they also have unsafe valuations.'
Another widely held view is that when the interest rate cycle turns and other assets start to look attractive again, bond proxies will be ditched and their share prices will fall.
At the moment, however, unless inflation rears its head sharply and suddenly, interest rates here in Britain won't be going up anytime soon.
Both Smith and Train are sticking to their guns. In an interview with Money Observer, Smith had two words of advice for people worried that Fundsmith Equity might suffer as a result of a change in sentiment towards bond proxies. Those two words were: 'Don't invest.'
He adds: 'Where else might you go? Cash and bonds yield nothing. Cyclical stocks and financials might benefit from a short-term bounce, but the consumer brands in the Fundsmith Equity portfolio are not as highly valued as many suspect on a long-term view.'
Smith has also previously made the point that for long-term investors the most important aspect of a business is the rate of return on capital it generates and can reinvest, rather than the valuation at which investors buy or sell.
Train holds the same view. He argues it is worth paying a premium price for quality growth businesses with rare qualities. Unilever and Diageo both account for just over 18 per cent of the trust's assets.