When defensive equity positions become more appealing, stocks that exhibit lower risk attributes, including low beta stocks and stocks in traditionally defensive sectors, can become expensive.
That’s the view of State Street’s chief investment officer, active quantitative equity, Olivia Engel, CFA, who noted that in recent months the increasing share market volatility has led many investors to pursue a more defensive position.
“One common path to building a more defensive equity portfolio is to favor low beta stocks. These stocks have become popular among investors – so popular that their prices now represent stretched multiples of forecast earnings,” Ms Engel said.
The valuation spread between low and high beta stocks has climbed steadily over the last 10 years, including a sharp rise in recent years. At the end of 2016, the spread was around 3.1 multiple points. Now, the spread is around seven.
“A second well-worn path toward a more defensive equity positioning is choosing sectors that are typically considered to be ‘defensive’,” Ms Engel said.
“It shouldn’t be a surprise that there is substantial overlap between these two paths: a portfolio constructed exclusively of stocks in the lowest quintile of beta tends to be dominated by market segments traditionally labelled as defensive.
Utilities, real estate, and food and beverage are the industry groups most highly represented in a low beta portfolio – and all are considered typically defensive sectors. The industry groups most highly represented in a high beta portfolio are autos, materials, and capital goods – all conventionally considered to be cyclical sectors.
Ms Engel noted that prices relative to earnings in low-risk and conventionally defensive segments have coincided with market flows.
“For example, in the past 12 months, ETF flows have been positive in utilities, consumer staples, real estate and communication services, but have been negative in discretionary, industrials, energy, materials and IT. They have been sharply negative in financials. Flows into low volatility ETFs have accelerated in the last 12 months, accumulating almost [$US26 billion] in that time,” she said.
“The problem with choosing stocks based on risk measures, such as beta or volatility, is that the other dimensions of risk are not taken into account. These risk dimensions can become return opportunities. For example, what is the interest rate sensitivity of the portfolio? What is the valuation multiple being paid for these low volatility or low beta stocks? If the goal is to generate strong returns on a risk-adjusted basis, then many more dimensions must be considered to create a portfolio of stocks built to navigate market uncertainty.”
Looking at the valuation of each of the conventionally defensive sectors, Ms Engel noted that the utilities and real estate segments as a whole are trading on a multiple of forecast earnings around two points higher than their long-term average.
“The utilities stocks in the low beta group on average are currently trading at a multiple of 19 times earnings, and the real estate and food and beverage segments are trading at an average of 30 and 21 times earnings, respectively,” she explained.
“When we think about investing defensively, risk measures are not enough. Valuation is also important, as are measures of financial strength, growth capability, or other measures of company quality. And the individual assessment of each stock is also not enough. Consideration of the interaction of stocks with one another (correlation) matters, too.”
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