Last week, while going through a pile of international research, I saw a report that shocked me: it was an analysis of defensive stocks with low valuations in Hong Kong. I hadn’t seen defensive-value-themed research of that sort for at least two years, as investment banks have been directing analyst coverage around the world towards technology and telecom stocks.
Now may indeed be an appropriate time to turn one’s attention toward “defensive” stocks. Such stocks come from industries typically less sensitive to economic downturns, such as consumer non-cyclicals (e.g. food, beverages, agriculture, tobacco, drugs, and food retailers) and utilities.
In the U.S., the economic expansion has been going on so long that analysts and investors have almost forgotten what is cyclical and what isn’t. Some have even proposed that, while technology industries were extremely sensitive to economy-led swings in capital spending in the past, they are no longer cyclical. I think this will be proven untrue when the next economic downturn hits.
It’s important to understand the nature of cyclical stocks, because when economies slow these positions can be hit particularly hard. Unfortunately, it’s difficult to predict when to switch out of cyclical industries because cyclical stocks typically fall well before negative economic growth figures are published, and before most people begin to expect declines. This explains the old investment saying of “sell cyclicals when they’re making big profits, buy cyclicals when they’re losing money.”
The economic expansion has directed investors’ attentions towards the companies that thrive in a high-growth economic environment. What little focus has been directed towards defensive stocks has primarily been due to specific growth factors, such as a blockbuster drug discovery or a popular new brand of drinks. Many years ago, investors were quite interested in companies able to steadily generate sales and profit growth percentages in the single-digits to low teens. Such companies were typically bought and held for the long term, favored for their ability to deliver growth in both good and bad economic times. Now, many such companies are scorned for being just too slow, or “boring.”
In emerging markets, defensive stocks have been similarly neglected. The market rebound from the lows of 1998 was propelled primarily by the performance of cyclical, technology, and telecom stocks responding to economic growth at home and in the export markets of Europe and America. Furthermore, in emerging markets, defensive industries have typically been populated with small to medium-sized companies, making them easier for global investors to ignore. Consequently, despite having positive growth characteristics, these stocks often trade at low valuations, throwing off relatively high dividend yields. I think it may be time to get off the cyclical bandwagon and start looking for some good defensive positions. Cyclical stocks around the world have already begun to decline, suggesting that an economic slowdown may be approaching. In the U.S., it appears that Fed rate hikes are beginning to flow through the system, slowing the economy. The same factors are at play in Europe, and the euros weakness is likely to simultaneously inflict inflation. Needless to say, a slowdown in the American and European economies would be bad news for emerging market companies exporting into those countries.
At the very least, it’s time for investors to examine their portfolios both in the U.S. and internationally to evaluate their exposure to cyclicals. I’ d bet most investors have accumulated a greater exposure to these economically sensitive stocks than they are aware, primarily because that’s what’s worked over the past several years. But it may not be prudent to assume this economic cycle will last forever.
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