A difficult time for economists

Neels van Schaik of Alphen Asset Management writes that despite market uncertainty buying high dividend payers provides investors with a high margin of safety.

Economists are already trying to forecast whether the economic recovery in the US will be U-shaped, V-Shaped or W-shaped.
 
Clearly no one knows, and under current circumstances trying to predict these macro economic outcomes with any degree of certainty will be more luck than skill. The current de-leveraging cycle in the US and Europe is unlike anyone has ever seen and trying to draw on similarities of cyclical down-turns in the past 20 - or 30 - years could lead to serious disappointment.
 
Offshore banks' balance sheets are in very bad shape and lending to consumers and businesses are likely to be kept to a minimum in the short term. In recent years risk has been completely mis-priced by these institutions, resulting in too risky assets on the balance sheets without adequate compensation for the risk. We should therefore expect banks to first become overly conservative, before credit markets normalise. This could take a very long time. These kind of cycles do not really normalise until you have gone from one extreme to the other. 
 
The US consumer has been the spender of last resort in recent years, and a global economic recovery has traditionally been very dependent on his fortunes. Unfortunately, the US consumer is intensive care and having to rebuild his balance sheet, could result in deferred spending for quite a while. In the last few years US consumer spending has been largely driven by the availability of credit and the consumers' willingness to borrow. Now, both consumers and businesses are hoarding cash to protect their balance sheets. Ironically, this strategy should have been implemented in the good times and cash should be employed in times such as these, when assets are cheap and the market is flooded with forced sellers.
 
It is quite clear that uncertainty will prevail into 2009. Further bad news should still be expected on the unemployment front in the US and Europe and news-flow generally will remain disappointing. Under current conditions, markets should remain volatile and rallies like we have seen last week will be driven by disparate news-flow.
 
Why would you then want to buy equities under such circumstances?
 
Due to investor sentiment that become so easily influenced by newspaper headlines and macro news-flow, financial markets seldom reflect the true value of a company and mostly reflect investors' perceived value of the company. Although we are likely to see some corporate failures in coming months or years, there will be companies that come through these economic conditions in even better shape. We would focus on companies that have the ability to keep investing for future growth without having to take on enormous piles of debt. In other words, companies funding capital expenditure mostly from internally generated cash flow.

High dividend yields have always been a very good indicator of value, but this is mostly applicable to companies where there is a long history of stable dividends, even in bad times, where families are significant shareholders or where most of the margin pressure has already been felt.
 
Buying such dividend payers under current circumstances where most companies are treated with similar aversion offer "high margin of safety" and lower-risk future returns.