Defensive vs cyclical stocks

23 September 2016

Ashburton Investments weighs in on opportunities in a low growth environment.

The rally in defensive shares may still continue as long as the low-yield environment persists, whereas it may still be too early for investors to start the switch into overweight positions in cyclical stocks. This is because cyclical shares tend to perform well when economies thrive and we are not seeing signs of that in many economies, including our own. The South African economy is expected to deliver average growth of merely 0.2% this year and then accelerating to 1% in 2017. Manufacturing, mining and construction companies are just some of the sectors that tend to do better during periods of strong growth and therefore considered cyclical.

On the other hand, the performances of defensive or non-cyclical stocks are not too closely linked to economic cycles. This basket of shares including healthcare, telecommunication and tobacco companies tend to show earnings resilience in times of an economic downturn. While governments globally have instituted several monetary policy measures to kick-start their economies, these actions have been slow to stimulate growth. Participants have started to consider the extent to which developed market governments can influence economic growth using fiscal stimulus over and above monetary policy measures, but the jury is still out on the potential success of such steps.

This suggests that the low economic growth environment could persist for some time to come.

Defensives vs cyclicals
Over the past two and a half years, the rally in defensive stocks has resulted in meaningful rating differentials between defensive and cyclical shares.

Certain sub-sectors within the JSE Industrials Index have seen valuations expand to multiples in excess of 20 times on the back of strong price performances, while some cyclical shares are still trading on price-earnings ratios in the lower to mid-teens. The global search for yield has been one of the main driving forces behind the rally in defensive stocks and understandably so.

In an environment where Japan’s ten-year government bond yield has moved into negative territory, with countries like Germany and Switzerland also offering negative long-term yields, South Africa and other emerging markets ranked very well from a yield perspective. South Africa’s ten-year government bond yield dropped from levels above 9.5% at the beginning of the year to the current level of roughly 8.8% as a result of the global search for yield.

Stocks like British American Tobacco, which offer forward dividend yields of over 4% are very attractive. The share has performed well over the past three years, not merely because of its yield, but also because of its expansive geographic footprint across various emerging market regions. For a South African investor, this share’s rand-hedge qualities also added support for inclusion across portfolios.

At the beginning of 2016 however, the dollar started to weaken, mainly as measured against the currencies of many emerging markets (including South Africa), a boost to commodity prices. Added to this, China’s monetary stimulus efforts also provided a tailwind to commodity prices and subsequently mining companies have experienced quite a significant rally.

In an environment where Japan’s ten-year government bond yield has moved into negative territory, with countries like Germany and Switzerland also offering negative long-term yields, South Africa and other emerging markets ranked very well from a yield perspective.

While many investors may have regarded this as a sign that it might be time to switch to cyclical stocks, we are still cautious on that theme, preferring to be measured in our approach and rather seek out stronger signs of a turnaround in global demand.

How it is positioned
In terms of its equity mandate, Ashburton has been adding to its position in global brewer Anheuser-Busch InBev because while yield is an attractive story, it is still important to have some counters that will offer growth and the brewer’s recent acquisition of SABMiller increases its footprint into the growth territories of emerging economies.

Despite Mediclinic’s low dividend yield, we have taken an overweight position in the hospital group, partly due to its attractive defensive nature and hard currency earnings.

We have remained quite significantly underweight Resources for some time, however we recently pared back the underweight positions following solid earnings growth in the latest reporting cycle, leading to a substantial unwind of multiples. Furthermore, the mentioned possibility of fiscal expansion by various economies may provide much needed support for the sector.

And while underweight Resources, our overweight has been to Financials where valuations have perhaps been the most attractive when compared to the overall index. While growth in the economy has been lacklustre, negatively impacting profitability for both the banks and insurers, dividend yields across these sectors have been very robust at a time when capitalisation is on much more solid ground relative to the period following the Global Financial Crisis.