Will the real “defensives” please stand up?

06 April 2018

Dougal Maple-Brown

Dougal joined Maple-Brown Abbott in 2001 and was appointed Head of Australian Equities in 2009. His responsibilities include equity analysis and portfolio management. Dougal attended the Advanced Management Program at Harvard Business School in 2014.

Despite some wobbles, the Australian equity market is still hovering around all-time highs when dividends are included. This means the market has enjoyed a bull-run of nine years since it started in March 2009, making it the longest bull-run in fifty years.

It is therefore unsurprising that valuations are somewhat stretched – the median industrial ex-financials price earnings ratio is hovering around 20 times. To be fair, the earnings level for the market as a whole isn’t that elevated with resource earnings still well below their peak, so we are unlikely to suffer the undesirable double whammy of collapsing earnings and falling multiples that we saw in 2008. In our view however, there are stocks today, and sectors more generally, where both earnings are high and multiples are full – these are red flags that we are on the lookout for.

Given markets are at record levels and valuations are full, prudent investors would often seek more defensive stocks to protect their portfolios in the event of a market downturn. Generally these defensive stocks will have run less than the market and are most often less exposed to the economic cycle. Thus in 2007, prior to the Global Financial Crisis (GFC), our portfolios were full of the brewers (Fosters and Lion Nathan, both now delisted), the supermarkets (Coles Group and Metcash), the telecommunications companies (Telstra and Singtel) and the wagering and gaming group Tabcorp. Together with a relatively high level of cash, these types of stocks positioned us well for the sell-off in 2008.

Clearly, no two cycles are ever exactly the same so it would be dangerous to draw too many conclusions from past cycles. However, it is also important to focus on what has caused the “valuation distortion” in each cycle. In 2000, the so called “Tech Crash”, we witnessed extremely high multiples for a relatively small part of the market (particularly in Australia with a tiny IT sector). In 2007 the multiples were again high, but more broadly based and on elevated earnings and thus the subsequent sell-off was particularly nasty.

In the current cycle we would argue the distortion has been caused by record low interest rates which in most parts of the world look like increasing. Thus, in our view the valuation risk lies in the stocks that have benefitted most from falling rates: both the interest rate sensitive sectors (such as Utilities and REITs) and the long duration growth stocks (such as Health Care). The fact that these sectors have been some of the better performing over the last few years only heightens our concerns.

Only time will tell how the traditional defensives hold up in the inevitable correction. However, given the valuation premium enjoyed by many of these defensive stocks, we find it very difficult to hold most of them in our portfolios today.

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