Powered by MOMENTUM MEDIA

A new breed of defensive equities emerges

Matt Reynolds
— 1 minute read

In the investing world, an unexpected development this year has been a serious re-examination of the notion of a “safe haven”. 

Matt Reynolds

In sailing parlance, a safe haven is associated with a protected body of water, which provides shelter. In war zones, a safe haven is a protected zone within a country for those seeking refuge. In the arts, a safe haven has sometimes been associated with a place or moment in time that offers artistic opportunity. 

In the investing world, a safe haven is usually associated with investments in securities or assets that provide some form of defence against prevailing turbulence. In other words, a place to park investments in market downturns.  

Advertisement
Advertisement

In the world of equities, historically “safe-haven defensives” have been regarded as a well-established equity sub-class group. These have included energy, utilities and consumer staples companies that generally generate consistent, predictable revenues. 

But in 2020, that sense of accepted wisdom seems to have changed.  

For example, energy stocks have been hit hard. This typically high-yielding sector has been among the hardest hit during the COVID-19 pandemic and continues to see bouts of volatility amid supply and demand uncertainties. 

In contrast, Amazon, which used to be regarded as a volatile tech stock in its early days, is now one of several high-growth companies that have matured into large, diversified businesses. From an equity investment perspective, it has behaved somewhat defensively as it has benefitted hugely from stay-at-home policies. 

These changes in the investment landscape have sparked a debate on what now constitutes a defensive stock.

Redefining defensive stocks 

As the traditional approach to defensive investing becomes less effective, what should investors look for in a defensive company today? 

Defensive characteristics can include reduced economic sensitivity, perennial demand, stable and predictable earnings and pricing power. In addition, a different perspective on valuation may be required. 

The current paradigm of rapid technological disruption has provided an environment where certain types of companies have not only provided attractive growth, but at the same time demonstrated the defensive attributes outlined above. 

In an effort to identify these new defensive investments, we believe there are two general themes that are shaping a new breed of defensive companies: new technology, which drives secular growth; and new business models, which drive lower cyclicality in earnings. 

New technology

Starting with new technology – new defensive companies might, for example, provide new products or services that have a relatively low market penetration, with strong potential for secular growth. This can provide a robust tailwind that can support growth even during economic downturns. 

There are a number of emerging themes under this new technology banner that point to potential new defensives.  

  • Digital media and entertainment companies that are increasingly being consumed as a staple service by newer generations – in effect, next generation utilities.
  • Connectivity enablers: these are the companies that supply the equipment and services necessary for the new age of connected devices and the internet of things.
  • E-commerce companies that provide the infrastructure that is enabling the rapid growth of e-commerce and digital payments. 
  • Companies engaged in the generation and distribution of renewable energy.

New business models 

New defensive companies also include those coming up with innovative strategies that can help boost resilience and reduce the cyclicality of their earnings. There are several emerging themes here that investors should observe.  

  • Safe havens in financials: non-bank financials, such as exchanges and data providers, that are less exposed to economic conditions. 
  • Digital brands: companies embracing digital initiatives to help improve their brand value – an intangible asset that can boost resilience. 
  • Enterprise staples: software companies offering subscription pricing models to improve the adoption and accessibility of their products with business customers. 
  • Alternative healthcare: looking beyond traditional big pharmaceutical companies to identify interesting business models elsewhere within the sector. 

Valuations of new defensives 

Given their attractive characteristics, many new defensive companies have seen their valuations increase this year. This has been driven largely by strong growth fundamentals, including revenue growth, high margins, robust free cash flows and rising profits. 

We believe that there are more meaningful and specific ways to value new defensive companies, however, based on their distinct characteristics and on an individual stock basis rather than by focusing on simplistic valuation metrics like price-earnings ratio. 

While headline multiples might appear expensive, the valuation premium is less significant when considering that: 

  • Current multiples are far from the unjustified levels seen in the TMT (technology, media and telecoms) bubble. 
  • Market caps are generally in line with profit contributions. 
  • Valuations are often supported by strong earnings growth and are more justifiable within a medium- to long-term investment horizon. 
  • Return on invested capital may be a more useful indicator than earnings for growing companies. 
  • Low interest rates can be supportive of sustainably higher equity market multiples for long-duration growth companies. 

Companies in traditionally more stable industries have typically benefitted from lower valuations and therefore lower volatility. However, in today’s world, every industry is at risk of disruption, so defensive investors are not necessarily safer parking their money in lower-valued, lower-growth sectors. 

What we have observed in 2020 is that the rate of change disruption has brought about has in fact accelerated, with an impact on business models and the long-term investment case for some incumbent “defensives”. It is our job to use our long lens and identify companies that can provide downside protection to investors in different types of markets. That is not a static thing, and if 2020 has taught us one lesson, it is to stay alert and adapt to accelerating structural changes that disruption can bring about. 

Matt Reynolds, Australian investment director, Capital Group

 

A new breed of defensive equities emerges
Matt Reynolds
ID logo

related articles

promoted stories

Website Notifications

Get notifications in real-time for staying up to date with content that matters to you.