One theory, advanced by the fund manager Neil Woodford, is that Unilever is a business that is growing at below its long-term average, whilst trading at a valuation that is above its long-term average, hardly a recipe for excellent returns.
Many of those negative on the investment case for the stock take the view that Unilever’s valuation has risen to its present height because it is a ‘bond proxy.’
This theory posits the view that because the Unilever dividend is viewed as being almost as reliable as the income that is derived from bonds, falling bond yields caused investors typically cautious in nature, to buy the shares of Unilever and other ‘bond proxy’ stocks as an escape from the low income available on bonds.
The income available from most bonds has collapsed since the financial crisis as an intended consequence of the policies of record low interest rates and quantitative easing pursued by global central banks.
So with the Unilever dividend higher than the yield on a government bond, and almost as safe, investors were prepared to pay an ever higher price, even if the company wasn’t really growing.
Of course, the valuation of Unilever would suffer if bond yields rose. And bond yields are expected to rise as economic growth improves and inflation and interest rates rise.
That would damage the investment case for Unilever shares, as the tourists from the bond market who have been buying the shares return to their natural home. In that scenario, Unilever shares would have to trade based on the company’s fundamental ability to grow. As a long-term investor, Woodford isn’t interested in buying shares because of unpredictable and perhaps short-term factors such as bond yields.
So if the company isn’t growing, he isn’t inclined to buy the shares.
But what if bonds yields continue to be below average?
Bonds are a source of income for pension funds and the retired, those investors have relatively little interest in growth, and just want a predictable income, which is what bonds provide.
In a world of ageing populations and people living longer, and so want income for longer, keeping demand for bonds relative solid relative to equities, which tends to keep bond yields low.
Inflation is bad news for bonds. But as the old have a much lower propensity to consume, they act as a brake on inflation.
Technological change may actually boost economic growth, but be deflationary. If the aggregate price of goods and services in the economy is falling, that increases the real purchasing power of the income derived from bonds, making them a more attractive investment.
But that scenario may not play out, and the price of bonds is presently very expensive, creating doubt about whether the risks outweigh the rewards. That may entice people to move into the equities that perform most like bonds in search of income.
So as long as the income from Unilever shares is higher than that available from the ‘safest’ segment of the bond market, that is, government bonds, then the share price looks justified.
If the yield on Unilever shares is higher than that of a 10-year government bond, then it looks like the share price is justified for ten years. Unilever’s range of brands and history implies that an investor can have ten years worth of visibility for income investors.
David Jane, a multi-asset investor at Miton, believes that this scenario is ‘plausible’ but added that in such an environment there is little capital gain to be had from shares such as Unilever because the bond investors buying the shares for income keep the valuation high, meaning that a lot of growth is priced in.
Jane takes the view that bond yields will rise from the current level, but may not return fully to the levels of the past. He does not currently invest in Unilever shares, because he feels the risks from a better global economic outlook outweigh the potential upside from the shares.
But what if, in addition to the bond argument, Unilever does grow.
Perhaps the most bullish of all investors when it comes to Unilever shares is Nick Train.
The eminent investor has the shares of the consumer goods giant as the largest holding in his Finsbury Growth and Income investment trust.
He believes that, even if the Unilever share price is being dictated by bond yield, the market is not fully appreciating the value of an income stream that is visible for decades into the future. He cited the example of the recent attempted takeover of Unilever by a consortium including the venerable Warren Buffett to buy Unilever vindicates his view that the shares are undervalued by the market.
Train also takes the view that Unilever shares can grow, as consumers, benefitting from the deflation wrought by technological change are able to spend more on consumer goods.
He also takes the view that emerging market consumers will also benefit from rising levels of economic growth, and become consumers of the products Unilever sell, in future.