Defensive investments. The very words have a reassuring ring. They bring to mind resilience, robustness and reliability.
These stocks, in the words of James Illsley, Citywire + rated manager of several JP Morgan UK equity funds, ‘are generally considered to be less affected by the economic cycle. They have a more predictable earnings stream not subject to big variations as GDP [gross domestic product] waxes and wanes.’
Defensive stocks typically come from sectors such as food retailers, food manufacturers, utilities, pharmaceuticals and tobacco.
‘Tobacco is an obvious example. But you can include businesses with moats, perhaps in terms of a strong brand, or a monopoly like a utility company. The common ground with all these is they are resilient over time.’
Therein lies their attraction as an investment, particularly in tough economic environments. However, Hall makes an important distinction: ‘There is a nuance between a defensive business and a defensive stock. Just because a business is resilient doesn’t mean it will be resilient in share price terms.’
Hall highlights British American Tobacco (BAT), which, according to Bloomberg data, traded on a price-to-earnings (PE) ratio of 6.7 on 31 January 2004, based on adjusted forecast earnings.
Today the adjusted PE multiple is far higher, at 18.4 on forecast earnings for 2017. The chart (below), which displays the reported trailing PE ratio for BAT, shows a relatively high 2017 multiple of 21.3.
Anthony Gillham, co-investment director of the multi-asset unit at Old Mutual Global Investors, also has concerns about the ratings of defensive stocks. He pointed out the PE multiples for US consumer staples (based on 2017 forecast earnings) stand at 21, compared with a lowlier 18.5 multiple for the S&P 500. ‘It is difficult to argue defensive stocks are good value at present,’ he added.
Illsley said many defensive sectors had been used as bond proxies. ‘They’ve been valued on a dividend yield basis, rather than a PE basis. This has driven down their yields and also driven some of the valuation creep we’ve seen.’
The defensiveness of particular business sectors can itself change. Jamie Forbes-Wilson, UK equities portfolio manager at AXA, said: ‘What appears defensive today won’t necessarily do so tomorrow.’
Forbes-Wilson said UK food retailers, for example, were being challenged by discounters Aldi and Lidl and internet offerings such as Amazon and Ocado. Utilities are under pressure over pricing and the tobacco industry is being hit by vaping.
Danish pharmaceuticals firm Novo Nordisk, a diabetes drugmaker, is another case in point. Hall said changes in the backdrop to diabetes led to a decline in its earnings power.
‘It was considered resilient and defensive but investors are now fearful,’ he said. ‘Markets perceptions of a business’s defensiveness can change remarkably quickly.’
Hall instead pointed to the current predictability and resilience of Rolls-Royce, which is one of two producers of wide-bodied aircraft engines and is not traditionally considered a defensive stock.
‘The nature of the business is predictable and resilient,’ he said. ‘Rolls-Royce has had a challenging two years but we think the market lost sight of some of its inherent cashflow characteristics.’
Traditional defensive stocks remain a key part of many fund managers’ portfolios. This is partly because their share prices are not driven by uncertain growth assumptions.
‘The benefits of having a core of defensive names is they offer a base of stability and certainty and multi-asset managers want to provide consistency and downside defensiveness,’ said Gillham. ‘The benefit of owning these stocks is you don’t have to bet on growth.’