Some fund managers are bemoaning ‘expensive defensives’ and warning that valuations in sectors such as healthcare and consumer staples look too stretched to justify holding them.
This, coupled with seemingly more attractive prices for cyclicals and the hope of improved global growth in early 2013, has seen a number of funds start to sell down their defensive holdings and allocate more to stocks that will do better in a recovering economic environment. Multi-managers have made similar moves.
But does the argument that defensives are too expensive hold true? I saw some research by Invesco Perpetual that made me think otherwise – and suggested that companies such as British American Tobacco and GlaxoSmithKline are fairly valued by historical standards.
Let’s be straight – it’s no surprise Invesco Perpetual is backing defensive companies. Critics of Neil Woodford note that his £12bn Invesco Perpetual High Income Fund and £9.3bn Invesco Perpetual Income Fund is heavily weighted towards sectors such as healthcare and tobacco.
Fair valuations in defensives
Presenting figures supporting the case for defensives, Mitchell Fraser-Jones, product director for UK equities at Invesco Perpetual, used a basket of 23 stocks defined as defensive shares by Morgan Stanley.
These companies have a market cap of more than £1bn each and reside in the consumer staples, food retail, healthcare, telecoms and utilities sectors – familiar names such as AstraZeneca, National Grid and Unilever.
Using the average P/E ratio of the FTSE 350 as the market and assigning it a base line score of 100, we can see that the average P/E ratio of the Morgan Stanley defensive basket over the past 14 years is above the market’s with a score of 109.1.
Since the start of the year, this score has fallen from about 140 and is today broadly in line with the historical average. And Fraser-Jones’ argument for picking the best defensives does not end there.
“It is also important to recognise that the average P/E of the basket consists of some relatively expensive dependable stocks and some relatively cheap dependable stocks,” he said. “We don’t invest in them all – we only invest in the ones that we judge to be attractively valued and where we have conviction.”
Fraser-Jones asked Morgan Stanley to recalculate the defensive basket using just the top ten constituents owned by Woodford’s Invesco Perpetual Income Fund – those “attractively valued” names such as AstraZeneca, BAE Systems and Imperial Tobacco that make up about 45% of the portfolio.
It showed the Invesco Perpetual defensive basket trades at a more attractive average valuation than the wider Morgan Stanley basket. In dividend yield terms, the Invesco Perpetual basket is higher than both the Morgan Stanley basket and the market.
Aren’t cyclicals more attractive?
Views differ on at what level defensive valuations should be considered attractive. Cazenove UK Equity Income Fund manager Matt Hudson recently told me: “If you have defensives you want them to look genuinely cheap.”
Fraser-Jones, on the other hand, said: “Defensive stocks are so-called because they tend to be less volatile and more dependable. They are, in other words, deemed to be higher quality. And quality deserves a premium.”
Cyclicals, after a tough year to date and a number of earnings downgrades, could still look cheaper than defensives. But their performance will largely depend on how well the economy fares in 2013.
Although stimulus efforts by the world’s central banks are expected to kick in and improve activity in the opening quarters of next year, many of the downside risks that have dominated 2012 remain in place.
Continued weakness in the eurozone and the re-emergence of Greece’s problems, the looming US fiscal cliff and the country’s $16trn-and-then-some debt mountain, concerns over the limitations of quantitative easing and persistently weak growth across the globe all sour the outlook for a coming, sustainable recovery.
Woodford recently said: “As 2012 has progressed it has become clear that the economic headwinds that others were confident would recede at the start of the year have instead become more intense.”
There’s a time to hold cyclicals and a time to hold defensives. Making the move depends, in part, on how you expect the bigger picture will work out over the next few months. But Invesco Perpetual’s data should caution against jumping away from dependable companies just on the suggestion they are too expensive.
