The ultimate allure of defensive stocks is stability, predictability and cash flow. The trade-off is the premium.
What are defensive stocks?
A defensive (or non-cyclical) stock is a stock with solid profit growth, revenues, earnings and cash flow irrespective of the prevailing economic conditions. Consequently, these stocks typically offer steady share prices, healthy and regular dividends and maintain attractive cash reserves.1
The economic landscape
During times of recession, economic downturn or bearish market outlooks, the defensive stock will unleash its true worth and withstand the ripple effects of such events to a far greater extent than highly correlated (or cyclical) stocks. In contrast, during times of expansion, the defensive stock will tend to perform below the market and so, by anticipating and identifying the inflexion points between these economic changes in a timely manner, the outcome should enhance.2
What to look for?
Indicators must seek to prove the core principle that a stock’s current and any derived forecasts, generates a positive and robust assessment of continued sustainability and predictability. This process is complex and must be comprehensive to hold true worth and whether the preferred approach is top down, bottom up or factor driven; the golden rule is to build an in-depth profile of the stock because ultimately in this scenario ‘certainty equates to value’.
A multi-dimensional framework developed by Pictet Asset Management (Pictet), which focuses on four key determinants of defensiveness is a good example of how to build a full-proof criteria. Pictet identified – profitability, prudence, protection and price - referred to as the “4P” framework (Table 1). In turn, each determinant has a category, namely - high return, stable return, resilient and attractively priced respectively, which when combined should prove or disprove the core principle sufficiently.3
Through this process or similar, a picture forms at two layers: (a) the company – for example its strengths, weaknesses, operational and financial risks and liquidity; and (b) the stock – for example its historic share prices and movements and its relationship to the company’s performance. Furthermore, both layers should also be assessed under a variety of economic conditions to understand its correlation to capital markets and whether the layers are responding congruently or divergently to macro movements.
Table 1: 4P Framework
- Operating returns on gross assets
- Operating margins and asset efficiency
- Special items
- Long term averages and trends
- Debt/Enterprise Value (EV)
- Cash Flows/Interest Costs
- Debt/Cash Flows
- 5 year asset growth
- Enterprise Value (EV)/Invested Capital (IC)
- Enterprise Value (EV)/Cash Flow
- Enterprise Value (EV)/Earnings Before Interest and Tax (EBIT)
- Dividend yield
Source: Nguyen, L (2017). “Defensive equities: a stable path to superior returns”. Pictet Asset Management
Assessments should be re-visited on a periodic basis and based on the premise the stock is able to produce reliable and predictable forecasts, each re-assessment, in theory, should maintain the predicted outcome within a certain tolerance.
Price being one of Pictet’s 4Ps, is effectively the buy/sell delta – the culmination or outcome of the other three determinants. The aim therefore is to assess whether the price of the stock is ‘attractive’ enough to buy or ‘too attractive’ (if owned) to sell. The predictability of the stock is in-built into the share price and so, if its weighting or importance is considered excessive, the value will therefore erode future returns and this could be significant. This so–called ‘premium’ could be due to investor sentiment pushing up prices or, in hindsight, the reliability of the stock was overstated, namely Pictet’s Prudence and Protection, was more correlated than anticipated.
Is the premium a price worth paying?
The answer is circumstantial and as mentioned earlier this process is complex and so wider influences may therefore act as an alpha counterweight, reminding us why the premium or ‘cost of defensiveness’ is not an exact science.
Notwithstanding the defensive stock is not a highly correlated stock, the markets can still influence its impact, as described earlier in the economic landscape section. Albeit the inflexion between recession-expansion is poignant, the before and the aftermath is significant for example, we are currently in a mature bull market, whereby ordinarily investors should be drawn towards the more exciting stocks meaning defensive stocks are ‘undervalued’; the extent depending on the length and amplitude of the bull run. Theoretically, following careful analysis, an investor could tick off the last of the 4Ps, price attractive, and prepare to execute the defensive strategy.
However, like tectonic plates the economic landscape too can unexpectedly shift. Since the Global Financial Crisis (GFC), unprecedented Quantitative Easing (QE), whereby central banks buy up bonds, has resulted in declining bond yields forcing investors to turn to equities and in particular the ‘pseudo bond-like’ defensive shares. The consequences of QE is clear, data between 1990-2008, shows little correlation existed between bond yields and the valuations of defensive shares and the wider market. After 2008, the correlation is pari passu; put simply, when bond yields fall defensive stock becomes more expensive and vice versa. So monetary policy is the curve ball in this instance and evermore so, because it is reactionary, its influence sits squarely at loggerheads with the predictable and reliable appeal of the defensive stock.4
Discounted cash flow (DCF)
Essentially, at its core cash is sacrosanct; be it how much or little is in the balance sheet, what is it used for, free cash flow patterns, coverage, etc. Thus research, as presented in the 4Ps or alike, shows that if there is a high degree of reliability then solid future cash flows can be produced, which not only is vital for liquidity purposes, but is a useful tool for valuations too.
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment, asset, company or project based on its future cash flows, namely the concept: time value of money. All estimated future cash flows are discounted using a cost of capital or discount rate to give their present values (PVs) and the sum of all PVs is the net present value (NPV).5
DCF = CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 + --- CFn/(1+r)n
CF = Cash Flow r = Discount Rate (WACC*) *Weighted Average Cost of Capital
Source: “Discounted Cash Flow DCF” (updated 2018). Investopedia
The NPV is a ‘today value’, which can therefore be compared to the ‘actual value’ thereby quantifying the margin of safety. Cash is absolute which makes it a compelling driver; but of course, one appreciates the discount rate is not.6
Defensive stocks, the essential go-to stock in the world of equities for risk-aversion and portfolio construction, can prove to be clearly a very effective strategy. However, it is not straightforward requiring detailed research, precision timing, an understanding of global markets and government interventions such as monetary authority stimulus and fiscal policy.
As demonstrated by the 4Ps, the goal is to find an acceptable balance, which quantifies and justifies the worth of the stock, both now and on an ongoing basis into the future. Defensive stocks intrinsically exhibit steadiness, but they are not immune to market movements and it is this level of tolerance, which may cause a breakaway from the expected, thereby undermining the core principle.
Predictability and reliability is the essential component, which ultimately leads to valuable cash flow projections and in turn robust valuations via DCFs. Furthermore, any investment, which can also demonstrate dependable no or low correlations to capital markets with a genuine lack of market or sentiment contagion plus diverse performance drivers (company, asset and/or territory related); can only then be seen to protect the ‘premium’ and regarded as a credible defensive long term strategy.