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Test your defences

After an unprecedented bull run and years of loose monetary policy, do assumptions about defensive stocks still ring true? Mark Robinson and the companies team report
August 17, 2018

It’s a curious time to be an investor, or an investment writer for that matter. Many familiar assumptions are under scrutiny because of fiscal policy initiatives undertaken in the wake of the global financial crisis. Those initiatives, labelled “the greatest monetary experiment in the history of the world” by Jacob Rothschild, have been accompanied by tightening regulation in a host of industries. The challenge for investors is in determining where their influence gives way to normal market fundamentals.

Against this backdrop, what are we to make of those sectors and stocks long held up as defensive plays in the face of economic and market downturns? The bulls may exhibit few signs of flagging, but markets will invariably turn (lest we forget, the Dow Jones Industrial Average suffered its biggest one-day points loss in its 122-year history earlier this year). So it’s right to examine whether the reputation of defensive stocks is still justified in light of the changes that have taken place in the past decade.

 

Altered assumptions on safe-haven stocks

Paradoxically – given their mired status and state support since 2008 – a good place to start is with the banks. Banking is one of those sectors that has traditionally been ascribed certain 'defensive qualities'; an ability to outperform general market indices during economic recessions or bear markets, although in the case of the former the banks are bound tightly to the general economic cycle. Indeed, the investment rationale for the banks was more closely aligned with the predictability of their income streams over their erstwhile status as safe-haven stocks.

In broad terms, you would also normally include consumer staples, utilities and healthcare within the ‘defensives’ category. If you’re concerned about market volatility, exposure to these sectors enables you to manage some of the downside risk to the equity segment of your portfolio while pursuing your desired level of long-term growth through other asset classes. But can we still hold firm to the old wisdom on the reliability of defensive sectors as quantitative easing (QE) programmes start to unwind? And what factors could have altered the defensive landscape?

 

QE gives way to rising interest rates

By now, it’s a well-worn yarn: years of ultra-loose monetary policy and historically low interest rates have debased fiat currencies and inflated asset prices, as central banks embarked on large-scale asset purchases and deployed unconventional tools to provide liquidity to the wider financial sector. With yields on fixed-income securities artificially suppressed, investors moved into equities and other risk asset classes in search of higher yields, increasing demand and therefore prices.

The trajectory of interest rates, though always critical, became the central consideration for investors. Equity investors increasingly took their cues from central bankers, whose signals on future policy came to dominate the debate over where markets were headed. Now, as the Bank of England, somewhat tentatively, ratchets up the UK base rate by another quarter point, the equity risk premium has been trimmed, and we’re left wondering about the point at which we’ll witness a decisive break in institutional support for risk assets. This assumes, theoretically, that investors still view current 10-year gilt yields as the genuine risk-free rate of return.

The monetary policy committee (MPC) voted unanimously to push the base rate to its highest level in almost a decade, but it doesn’t seem as though a broad consensus has emerged on where the base rate is headed, or the extent to which rates can be increased, even though the market had priced in the rate rise ahead of the decision earlier this month.

This is clearly an issue if you’re considering shoring up your portfolio with low-beta defensive stocks, which are generally sensitive to interest rate increases, particularly if they’re also income stocks. As bond yields climb higher, there is less incentive to own a dividend-paying stock versus a safer bond. Consequently, the relative valuations of these stocks tend to fall as rates rise.

Presumably, the move, taken amid mixed signs from the UK economy, could provide support for sterling against a fractious political backdrop, but equity markets could feel a chill if a perception takes hold that the MPC is now taking a more hawkish stance on interest rates, as investors weigh up the likely implications for debt servicing and the cost of capital.

 

Grin and bear it – waiting for the correction

Across the Atlantic (and assuming no correction has taken place before this magazine hits the newsstands), the US stock market will reach its longest bull run on record – a distinct possibility given the Federal Reserve recently upgraded its view of the economy to “strong”, trade wars notwithstanding.

Closer to home, with the FTSE 100 hitting record highs through 2018, albeit with greater accompanying volatility, opinion is still divided as to whether the near-decade-old bull market is about to grind to an abrupt halt. A decent macroeconomic outlook, including a buoyant jobs market, is set against dizzying levels of sovereign debt, a flattening yield curve and rising rates.

Yet many analysts still believe that the UK benchmark is undervalued, at least relative to other national indices. Certainly, the FTSE 100, with an average price/earnings (PE) ratio of 12.9 and a dividend yield of 3.8 per cent looks far more compelling value than any of its major rivals, except for Hong Kong’s Hang Seng index. It has operated within a relatively narrow band over the past five years, save for peaks around 35 at the end of 2015 and 2016. These were a direct result of a heavy weighting towards natural resources stocks, which had suffered a period of abnormally low profits, driven by a collapse in commodity prices.

 

Utilities: the doyen of defensives?

If you’ve ever played the board game Monopoly you may have noticed that the two utilities – electricity and water – don’t have the same growth potential as, say, Mayfair or Bond Street. They cost £150, and rent is four times the dice roll if one utility is owned, or 10 times the dice value if both are owned. Not bad returns in the early stages of the game, but the returns are relatively insignificant by comparison to the developed real estate assets as the game progresses.

It’s not known if Professor Stephen Littlechild was a fan of the board game when he was commissioned by Margaret Thatcher’s government to design a regulatory mechanism that would govern the privatisation of the UK’s telecoms monopoly in 1982.

Even if he was, which is a fair bet given that 250m units have been sold, he may not have known that the game was created to demonstrate that an economy that rewards wealth creation is better than one in which monopolists work under few constraints. The irony wouldn’t have been lost on Professor Littlechild, as he had been tasked with formulating an equitable system that would square the competing interests of City backers, HM Treasury, UK households and the utility itself – British Telecom. "The Littlechild formula", as it came to be known, went on to become the effective template for the raft of privatisations that were to follow.

Critics of the process claim that the privatisation of British Telecom was ideologically driven, pushed through in haste and finalised without sufficient consideration as to whether ‘natural monopolies’ could ever be set within a competitive framework. Indeed, some years later, Professor Littlechild, the then electricity regulator, questioned whether the structure of the industry was fit for purpose, lamenting that there wasn’t enough diversity in generation, nor “convinced that there ever will be”.

Not that you’ll find too many investors bemoaning any perceived competitive deficit in the utility markets. After all, it’s the predictability of the privatised electricity, gas and waterworks – the mandated predictability – that has made them such reliable, and hitherto lower-risk, defensive plays.

And yet, two decades on from Professor Littlechild's critique, and energy giant SSE (SSE) reports that its retail numbers are in decline, as the energy giant is forced to contend with what it describes as “a rapidly evolving competitive landscape”. The number of retail accounts dropped to 8.03m at the March year-end, from 8.47m a year earlier, as price-savvy customers decamped to new, nimble entrants to the market, which are challenging traditional players with aggressive pricing.

There are now further draws on utility capital to consider. Readers will note a narrowing in the divergence towards the end of the chart (see chart above), specifically from 2016 until the present day. In our view there are two factors that have harmed the performance of the utilities sector in recent years: the rise of renewables and increasing political pressure.

Of the two, the rise in renewable energy has a narrower impact, as it poses no threat to water companies. As new forms of renewable energy generation emerge, such as solar, wind and fuel cell power, the current model of centralised generation – using a small number of  large, predominantly coal-fired power plants to create electricity that is then distributed across a broad area – comes increasingly under threat. As smaller forms of generation emerge, as well as increased storage capacity, they threaten to chip away at the business models that have sustained both the network and energy supply companies.

All the big energy groups are making investments to place themselves at the forefront of this shift, for example through SSE’s involvement in wind generation or National Grid’s (NG.) venture arm, but the relative accessibility of these technologies compared to coal or nuclear power plants means the defensive characteristics of these companies is diminishing.

The competing – and increasingly incompatible – imperatives that drive the privatised utilities are now conspicuous. At the end of last year, Ofgem confirmed that the ‘big six’ energy suppliers had increased their profit margins in recent years despite losing millions of customers to challenger companies. A key objective of the industry regulator is to stop price gouging on the part of utilities, but the energy companies have been relying on less engaged consumers sticking to standard variable tariffs, rather than opting for cheaper fixed-term deals.

However, net profitability – and cash flows – within the sector will come under pressure as legislation to cap poor value energy tariffs recently completed its passage through parliament. Once fully implemented, the legislation will put the onus on Ofgem to cap standard variable and default energy tariffs. For shareholders in the ‘big six’, the effect will almost certainly be material, given that the Competition and Markets Authority (CMA) has estimated that punters have been overpaying the main energy suppliers to the tune of £1.4bn a year.

The withdrawal of that level of surplus liquidity has direct implications for cash flows – and by extension the funding of dividends. And the income element is central to the investment case. Shares in privatised utilities are often referred to as ‘proxy bonds’ – a reflection of the way that regulatory frameworks were structured to meet the wave of privatisations, along with their subsequent implementation by industry watchdogs. The attractions are obvious – low-risk, low-beta, predictable well-covered income streams – and tailor-made for a defensive play. Investors would now be justified in wondering whether the prospect of rising interest rates, along with the beefed-up regulatory strictures, will silt up those streams.

The historically low interest rate environment is also relevant, not only because it effectively increased the attractiveness of utility stocks given their inflation-busting income streams, but because the cheaper cost of capital supported free cash flow generation. Unfortunately, it enabled utilities to crank up the leverage.

Admittedly, utilities, by their very nature, often carry high debt levels as their infrastructure requirements necessitate heavy, periodic capital commitments. It’s not unusual for the privatised utilities to carry a high amount of debt relative to their available equity, but in the case of the privatised water utilities, a focus on dividend pay rates served to degrade industry balance sheets. Borrowings have soared while net profits were invariably destined for shareholders. Arguably that's come at the expense of the country’s infrastructure; another case of skewed incentives. Little wonder so many home-grown water companies are now in the hands of foreign competitors, sovereign wealth funds and pension schemes.

Since utilities typically carry high debt levels, they are subject to interest rate risk, but there’s potentially a far more profound threat on the horizon. Some politicians think any surplus capital generated by these companies shouldn’t end up in the pockets of shareholders. The prospect of a national government led by Jeremy Corbyn no longer seems quite so fanciful, so another threat to the status of utilities as the ultimate defensive play, somewhat ironically, is also ideologically driven. In September 2017, Labour’s shadow chancellor, John McDonnell, promised to bring “ownership and control of the utilities and key services into the hands of people who use and work in them”. It’s almost as though he’s intent on securing the means of production, but whatever the shadow chancellor’s motivation, the pledge could conceivably kill utilities stone dead as a defensive investment option. MR & TD

 

Pharmaceuticals: in sickness and in health

Humans are never going to stop needing medicine. According to the NHS, over half of the UK population takes prescription drugs, while 4.5bn prescriptions were written in the US in 2017 alone. Modern medicine has helped extend global life expectancy by 10 per cent over the past decade, creating a virtuous cycle for drugmakers; the longer we live, the more medicines we need. Over the next five years, global drug expenditure is expected to rise by more than a quarter to $1.43 trillion a year.

It is fair to argue that pharmaceuticals make for strong defensive stocks. Indeed, on the morning after Britain voted to leave the EU (when investors were in panic mode), pharma giants AstraZeneca (AZN) and GlaxoSmithKline (GSK) were two of the best-performing shares. Amid all the perceived uncertainty, investors sought to capture a slice of the industry’s reliable sales, high margins and strong cash flows.

But while demand for medicines continues to rise, other factors may have dampened the sector's defensive qualities. Drug pricing is an obvious threat. Aside from political noises, the US has witnessed a rise in consolidation between insurers and pharmacy benefit managers (who act as dealmakers between drugs companies and insurers) which, according to broker Liberum, could “end the perverse incentives which favour very high priced specialty care drugs” and ultimately bring the cost of these medicines down.

For pharmaceuticals, that’s problematic, as speciality care has been a major target of their investment in recent years. Many of the world’s largest drugs companies have filled their pipeline with niche medicines in the hope that high prices and generous patent protection will help recoup the high cost of investment. AstraZeneca, Eli Lilly (US:LLY) and Novartis (CH:NOVN) are just some of the companies that rely on big sales from a small number of new drugs to return to earnings growth.

The rise in specialty care has also added to the risks of investing in big pharma. Historically, drugs made using chemical experiments had a relatively high chance of success by the time they reached the third and final phase of trials. Following approval, drugs companies would gain long-term patent protection and could market their products to enormous populations via their large commercial platforms. Modern improvements in genetics mean personalised medicine and targeted therapies are becoming the norm. These involve biological compounds, which are much harder to turn into effective drugs than chemical ones. It also means smaller patient group sizes and specialist physicians, which makes commercialisation far more challenging.

These challenges are hampering big pharma’s ability to pay generous dividends – a trademark of the defensive sector. AstraZeneca and GSK have both paused their progressive dividend policies as they seek to launch new products to re-ignite underlying earnings growth following a period of intense competition from unbranded generic rivals. Astra is looking particularly risky as, after several years of earnings per share (EPS) declines, it is now at the mercy of a small number of high-risk final-phase drugs trials. GSK’s medium-term growth looks slightly more reliable, but the group’s recent investment in an early-stage genetics company shows that management has got a taste for the high-risk, high-reward game as well. MB 

 

Sin stocks: reliable profits

What’s one way to insulate returns regardless of market conditions and to ensure stability of the business and its cash flow? Get the customer addicted to your product. That may sound harsh, but it’s a strategy that’s worked for a number of so-called 'vice stocks'.

Tobacco companies are the most obvious example. Cigarettes are highly addictive and still make up the bulk of revenue at both UK-listed tobacco giants Imperial Brands (IMB) and British American Tobacco (BATS). Both are pouring money into the development of “next-generation products”, such as vaporisers and tobacco heating devices, but these new offerings should continue to keep their customers coming, as it’s just another way of delivering the addictive nicotine hit.

For those looking for income in a downturn, Imperial Brands hasn’t cut its dividend since 1997, and only then because it was spun out of Hansen and listed as its own entity. It’s committed to increasing its dividend by at least 10 per cent over the medium term. British American Tobacco’s last cut to shareholder payments was 1999, and is committed to pay out at least 65 per cent of group earnings to investors. This isn’t to say the share price has been stable for either group over the years, but it’s impressive that the tobacco groups have remained so reliable from a cash-yielding perspective.

The booze business offers its own defensive qualities, and a larger market. When times get tough, people want a drink. When things are good, people still want a drink. It can also go hand in hand with social activities, which are unlikely to disappear in a downturn as people need to keep their spirits up, so to speak. But do they want their drink in a pub, or at home?

If they want it in a pub, then which one? There are more pubs in the UK than there are Starbucks globally, so competition is fierce. Some groups such as Fuller, Smith & Turner (FSTA) and Young & Co’s Brewery (YNGA) will boast that their premium positioning in the sector will keep them steady no matter the economic environment, and that people will continue to indulge in small luxuries such as a pint of good beer. Others, like JD Wetherspoon (JDW), would argue that it’s their low prices that will keep punters coming back for more.

But no matter where these pub groups sit on the premium to budget spectrum, they’ve all had to deal with unprecedented increases in their cost bases over the past year or so. Business rates have gone up, as has the national living wage, the apprenticeship levy and the cost of some supplies. There’s also a great deal of uncertainty around the impact of Brexit on labour and overheads, as many pub workers and stock come from continental Europe. Such factors could weigh on investor sentiment and drag on cash flows, which could make the stocks less defensive in a downturn.

A downturn could make it more appealing to have your mates around to your home for a cheaper drink than the pub equivalent. If you’re buying alcohol at a grocery store, there’s a good chance that brand is owned by Diageo (DGE) – think Smirnoff vodka, Tanqueray gin and Guinness. The geographies the company operates in and the products it offers are well diversified, which should limit the effect at group level of a downturn or shift in consumer appetite in any one region. The alcoholic beverage maker recently announced a £2bn share buyback programme, suggesting it’s confident in its future performance and perhaps that its share price is undervalued. JF

 

Aerospace & defence: a bulwark or non-correlated?

Are defence stocks defensive? That depends on how one interprets the meaning of defensiveness. True, military suppliers should theoretically enjoy perpetual demand, because they are beholden to governments’ defence budgets. However, these budgets depend on various factors – including, but not limited to, other government spending priorities; targets set by international alliances, for example the North Atlantic Treaty Organization (Nato); and, last but not least, the geopolitical context at any given time.

For now, from the viewpoint of defence companies, the US’s military investment plans look particularly promising. It’s no secret that Donald Trump is a strong advocate of increasing defence expenditure. At the Nato summit in Brussels earlier this year, he reportedly told Nato allies to spend 4 per cent of gross domestic product (GDP) on defence – double the current objective. And, at the time of going to press, he was in the process of reviewing a whopping $717bn US defence budget for the 2019 fiscal year.

In its latest interim results, Ultra Electronics (ULE) said it was well positioned “in areas of priority spend with significant exposure to the strengthening US defence budget”. And the group’s order book offered foundations for optimism – up 19 per cent to £969m. Of course, this should be seen against a backdrop of a number of recent setbacks for Ultra, including cost overruns of £6.1m on development contracts at US-based missile detection manufacturer Herley.

Elsewhere, analysts at JPMorgan Cazenove highlighted the importance of US defence spending in their review of BAE Systems (BAE). Indeed, the broker reckons one of BAE’s core strengths is that 40 per cent of 2017’s sales stemmed from US defence. It expects these sales to grow 7 per cent per year on average between 2018 and 2021. And a significant proportion of sales also stemmed from the Middle East last year.

That all said, the outlook for the UK’s budget is rather less clear. JPMorgan deemed it a concern that 21 per cent of BAE’s sales last year derived from the UK, while the UK Ministry of Defence (MoD) is apparently overcommitted by up to £20bn against its available budget over the next 10 years.

The UK has hit Nato’s goal of spending 2 per cent of GDP on defence each year since 2010. But the MoD is currently reviewing its spending plans, under Defence Secretary Gavin Williamson’s Modernising Defence programme. This was launched in January 2018, and – aside from some headline conclusions released in July – there isn’t much clarity yet on what the ultimate outcomes might be.

As things stand, per a recent House of Commons Library briefing paper (briefing papers provide research to MPs), the UK’s defence expenditure is planned to rise from £35.3bn in the 2016-17 fiscal year to £37.1bn (in real terms) by 2020-21. But clearly defence budgets around the world are subject to change. Perhaps they’re not as reliable as one might initially surmise.

A lack of correlation with the broader market is another traditional indicator of defensiveness. Over the past 10 years, there have been periods of discrepancy between the share price performance of the FTSE 350 Aerospace and Defence index and the overarching FTSE 350 index. But this should be seen in the context of it being difficult – and potentially dangerous – to extrapolate a meaningful relationship (or lack thereof) from historical data. HC

 

UK defence expenditure

Reported outurn and planned defence total departmental expenditure limits

   Real £ billion Annual real terms change
  Cashat 2016/17 
  £ billionprices £ billion%
2006/07Outturn34.040.6   
2007/08Outturn37.443.6 +2.9+7.2%
2008/09Outturn38.643.8 +0.2+0.6%
2009/10Outturn40.245.0 +1.2+2.8%
2010/11Outturn39.543.4 -1.7-3.7%
2011/12Outturn37.240.3 -3.1-7.1%
2012/13Outturn34.336.4 -3.9-9.7%
2013/14Outturn34.636.1 -0.3-0.8%
2014/15Outturn34.435.4 -0.7-2.0%
2015/16Outturn35.135.9 +0.5+1.5%
2016/17Outturn35.335.3 -0.6-1.6%
2017/18Plans36.936.4 +1.1+3.0%
2018/19Plans36.935.8 -0.5-1.4%
2019/20Plans37.936.3 +0.5+1.3%
2020/21Plans39.537.1 +0.8+2.3%
       
Notes: Outturn figures are from MOD and Plans figures are from MOD 2016-17 Core Tables. Defence Spending in 2003/04 to 2008/09 is the sum of the Resource DEL plus Capital DEL minus Depreciation and Impairments and from 2009/10 Fixed Assets Written On/Off have also been removed from the Total DEL figure. From 2011/12 the depreciation/impairments figure now includes stock written off. Plans have been calculated from MOD annual report to be consistent with previous outturns by the House of Commons Library and Scrutiny Unit.
Sources: MOD, Defence Department Resources 2017, table 1; MOD, Annual Report and Accounts 2016/17, Annex D Core Tables, p. 203; HMT, GDP Deflators December 2017.

Source: House of Commons Library https://researchbriefings.parliament.uk/ResearchBriefing/Summary/CBP-8175