If you must hold equities, during volatile times it pays to be invested in the ‘safest' businesses. But Martin Steward finds a changing world challenging old assumptions about which sectors contain these defensive stocks
It would be easy to overstate how radically the turmoil of 2011 confounded traditional expectations for equity sectors.
But now look closer. Utilities, once the byword for steady cash flow from haplessly dependent consumers, disappointed. At 2%, their return barely beat industrials - a cyclical sector if ever there was one. And both industrials and consumer discretionary tidily beat the broad market, which was dragged down by devastation in specific cyclicals like materials and financials. Even healthcare's outperformance was less about its classical defensive status and more about a rally after a multi-year sell-off around fear of the ‘patent cliff'.
Furthermore, the low beta of some sectors masks considerable intra-sector dispersion. In healthcare recent years have seen mid-cap medtech companies like Electa and Fresenius outshine big pharma; and even the big-pharma rally has seen differentiation between those with more exposure to the patent cliff (like AstraZeneca) and those with less (like GSK). Similarly, the 2% return to global utilities looks much worse if we remove outperforming US companies.
The utilities example could tempt one to think this was all about country risk overwhelming sector risk. Regulated revenues used to be defensive, but being trapped in their domiciles now makes many utilities sitting ducks for cash-strapped governments looking for windfall taxes or votes from hard-pressed consumers. But that oversimplifies the matter. Utilities in less regulated markets may be less sensitive to tariff reductions, but they also miss out on subsidised fuel input prices -making them more sensitive to the macroeconomic ebb and flow. So US outperformance is partly about de-regulated markets, but also plummeting natural gas input prices, and in the similarly deregulated UK market water has markedly outperformed power. Moreover, even the most financially-stressed countries host surprisingly resilient names.
"The idea that certain countries are defensive and others are not is a gross mistake," says Steve Cheetham, a senior portfolio manager at AllianceBernstein. "Take [Portuguese energy utility] EDP: it's had a pretty darned good year as a good-quality company in a defensive sector in a country with significant problems."
Country risk has become more important over the past five years, especially in Europe. But to isolate it is to miss how it has become more important. In the past, developed-market political and country issues would be temporary distractions from the business cycle and company fundamentals. Similarly, the troughs in the business cycle were short-term interruptions in the onward march of global growth. In both cases, the feeling is that the cyclical has ceded to the structural.
"Fiscal policy, debt reduction, the euro crisis - all of these things will go on for much longer than previous political issues," observes Michael Schmidt, head of equities at Union Investment. "At the same time, growing economies happen also to be tightly-managed economies. Overall we are in world where politics matter more, after 20-30 years of deregulation and getting used to politics having less and less of an impact."
Lucy MacDonald, global equities CIO at RCM observes that ‘risk' is now defined as the risk of capital loss rather than cyclical exposure: "Whether that's down to currency exposure, liquidity events, fiscal grab, regulatory change, fraud, or whatever, the point is these are not cyclical losses which, by definition, you can get back."
Bruno Paulson, co-manager of Morgan Stanley Investment Management's Global Franchise fund, puts it another way: "In the old days, defensiveness was about beta," he says. "In the new environment you have to think harder about what's actually going to work to avoid destruction of capital."
If you want to be defensive the first question is what you want to defend against, notes Didier St Georges of Carmignac Gestion - and traditionally, that was merely the trough in the cycle. This time around, the ordinary cycle is being overwhelmed by two major, long-term, disruptions or breaks with the past. "One is a dislocation of the financial system and the resulting difficulty to tap the capital markets," he says. "The second is the phenomenon of cycles being out of synch in different regions - as opposed to the global downturns of the past."
Comparing telecoms with utilities shows how structural changes to specific industries can radically alter their perceived defensiveness over the longer-term. But today's structural changes have cross- and intra-sector impact. The new defensives are not merely the old ‘non-cyclicals for the short-term', but companies that are on the right side of three structural trends: persistent political risk; divergent growth; and the rising cost of capital.
As Union's Schmidt stresses, that means that the three pillars of today's successful stocks - quality, real growth and income - are each necessary but not sufficient. It is no longer good enough to seek out balance sheets with cash buffers if that cash cannot be invested for long-term growth. "Cash is a great buffer when things get tough, but it if it starts to have a detrimental effect on return on capital then eventually it will have a detrimental effect on the valuation multiple," he says. "And if it is going to be used up by a business with negative real cash flow it isn't really defensive at all."
That means not only an appropriate balance sheet, a sustainable business model with visible revenues, and a cost base that can be managed flexibly - but also quality management that knows how best to deploy its assets and has the nimbleness to adapt to the newly-emerging environment.
"There is definitely a quality growth cycle going on," says Schroders' head of European equities Rory Bateman. "You need to be able to demonstrate structural growth in your business, with a balance sheet appropriate to that growth profile." ‘Quality' has the advantage of combining the financials of a company with its business strategy, agrees Emmanuel Morano, head of equities at La Française Asset Management. "The nature of defensiveness is changing," as Lode Devlaminck, CIO at Hermes Fund Managers, puts it. "Now genuine growth is important in an environment starved of growth, but also transformations in business models."
The three pillars can and do cut across traditional defensive-versus-cyclical lines. Investors find them in businesses in highly cyclical tech sub-sectors like Taiwan Semiconductors or Intel, or consumer discretionary names like Home Depot, that have strengthened balance sheets to maintain growth as the cost of capital rises; companies that can position for development like the cycle-busting US shale gas revolution; or winners from losing sectors who capture market share - Taiwan Semis again, or even the US regional banks that have tidied-up balance sheets and acquired competitors in anticipation of a recovering mortgage market.
Similarly, regionally-diversified revenue sources, and especially exposure to growing markets, are not necessarily strengths of traditionally defensive industries, but certainly have been strengths of traditionally cyclical ones. "If you were in Japan in the 1990s, what was defensive?" asks St Georges. "An exporter to the US. A Japanese utility was not defensive at all."
The poster children for this trend have been in branded consumer goods, with their enormous pricing power in new, fast-growing markets. This covers everything from discretionary names like BMW, Audi and LVMH to wielders of global staples brands like Nestlé and Unilever - but even the staples serve to illustrate how the new environment is challenging the old sector-based assumptions. Staples that used to grow their top lines by 3-4% per year just about sustained that with good free cash flow. In domestic developed markets, that growth has slipped to 2-3% - but brands that translate in the world's growth markets not only maintain 4% top-line growth but boost it to 5-6% and counting.
This cuts across sector definitions in a couple of ways. It leads to increasing intra-sector dispersion, of course (in telecoms, newer companies focused on growth markets because big incumbents had domestic consumers sewn-up - and they now look safer than the old ‘defensives'). But it also questions how we come to define a sector as ‘defensive'. It's not just that the losers in traditional defensive sectors are destroying capital: "If, with globalisation and the opening of new economies, world leaders in food are delivering growth of 5% or more even with price appreciation, can we consider food a defensive sector anymore?" asks Morano. "I don't think so."
Reasonable valuations limiting downside risk were a fundamental aspect of traditional defensive positions. MacDonald is not alone in her concern that the luxury goods sub-sector looks "over-extended". Cheetham agrees. But he also worries about the "crowded trade" in the new breed of pro-growth staples: "Nestlé is a very good company, but it doesn't half look expensive." Bateman at Schroders says much the same (indeed, he worries more about growth disappointments for staples than for luxury goods).
Against that Paulson "argues strongly" that quality remains undervalued, precisely because the market has taken its eye off the longer-term. "Conventional wisdom suggests Nestlé is not cheap, but we think that's based on a view that forward earnings are more vulnerable than they are."
Derek Mitchell, a UK equities manager at Royal London Asset Management, agrees that paying up for "longer-term attributes" makes more sense than "plain defensives" in a low-growth, deleveraging environment. "We are going to have to get used to paying higher multiples for these quality growth stocks," he says. "In the UK we've always had a problem once a P/E gets to 15. Look at ARM's shareholder register - it's all American."
The disagreement arises because we are now talking about growth, and therefore contested discount rates. Traditional defensives' earnings growth was limited precisely because those earnings were steady, which discouraged wild overvaluations and contributed to their low-beta profile. If defensive means ‘low-beta', once valuations begin to price-in less visible future earnings growth the downside risk becomes too great to support positions in a defensive portfolio. Pim van Vliet, senior portfolio manager for Robeco's low-volatility equity strategies insists that he is no longer able to buy much in the way of "quality growth", for example.
Of course, this just emphasises the move from a relative to an absolute-risk world. But if quality growth is the new defensive, aren't we simply acknowledging that there is no such thing as defensive anymore? Not necessarily. Remember that each of the three pillars is necessary but not sufficient, and that the third is income.
"Quality is clearly more growth-oriented than defensive, but we are not necessarily talking about high betas," says Morano. "High-beta means financials, low-beta means defensive, but in between you have stocks and sectors trading in-line with the average." MacDonald agrees, pointing out that RCM thinks about growth as separate but potentially overlapping with quality: "Good returns, quality management, good capital allocation - these don't mean high beta, but more likely relatively low dispersion around the average."
Paulson says that looking for stocks that are not excessively cyclical, have decent returns and low leverage naturally drives you away from large banks, insurers, utilities, mining or energy companies: "The top-quality consumer staples brands are your natural home."
But the qualifiers are important: "top-quality brands" are not the lowest-margin products in the staples industry. And this middle ground is more sectorally-diverse than Paulson suggests here, because finding income tied to both quality and real growth requires business focused, not on high-volume, high-competition, low-margin markets with captive consumers, but on recurring revenues from higher-margin niches.
Philip Dicken, head of European equities at Threadneedle Investments, calls this "the Nespresso model" - after that triumphant combination of high-margin consumer discretionary (coffee makers) with low-margin consumer staple (coffee) - and its natural home extends well beyond consumer goods and into the cyclical industrial and capital goods sectors. Paulson himself picks out Finland's Kone as an example: "You have glorious recurring revenues there - you install a lift and spend 25 years servicing it." Schmidt at Union picks out Tyco International and Sumitomo Corporation, but also stocks like Enbridge and Kinder Morgan from the energy sector.
It would be wrong to say that the new environment completely invalidates the old defensives-versus-cyclicals dichotomy. For this third pillar of income, traditional defensives will always be the best place to start looking. But if you accept that we are no longer in an ordinary business cycle, you can no longer stop there: you must augment income with quality and real growth to get through a longer-term adjustment. You will have to abandon some traditional defensives in favour of some, perhaps surprising, cyclicals. It may increase your volatility, but it will probably improve your chances of longer-term real capital preservation.