Are defensive stocks now too much of a risk?
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MoneyWeek editor-in-chief
Merryn Somerset Webb Feb 13, 2012
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If you have spoken to a fund manager recently, you will think that the best things you can possibly buy to see you through these tricky times are solid defensive stocks.
You will need them to have 'safe' balance sheets – not too much debt, and good piles of easily earned cash – and to pay good and rising dividends. You will want them to be in diversified global businesses. You will know all of this even if you haven’t spoken to a fund manager for a while. I’ve been telling you to buy these very stocks for several years, and they’ve performed very nicely for all of us.
However, I have bad news. These stocks are no longer quite as safe as they were.
Why? A few reasons...
First, they have become a consensus trade. That’s fine, as long as it lasts, but it also means they are no longer just held by people who believe that long-term investing means buying quality. They are also being held by momentum traders, who (much as I like them) could easily lose interest and sell out when they think they’ve found more exciting pastures.
Second, their prices have risen. When compared with average valuations, that makes some of them expensive.
Third, some have become less reliable. While defensives as a theme can sound brilliant, there is a lot of company-specific risk around. Look at what happened to Tesco: it was deemed a defensive stock by the market, but, thanks to the failure of cash-strapped consumers to buy as much as they might have, it produced disappointing earnings – and a disappointing share price performance. It won’t be the only one.
However, alongside these fairly obvious points, there are some bigger reasons why holding quality cash-heavy defensives might not be the 'no brainer' that many suggest it still is.
The world’s big corporates currently have bizarrely high profit margins. What’s more, their profits have risen even in the face of the financial crisis and rolling recessions. That’s why you want to hold them, of course. But it is worth asking how they got to have such hefty margins.
According to Andrew Smithers of Smithers & Co, the answer is performance-related pay. Incentives introduced over the past decade or so have changed executive behaviour so that they no longer hang on to high-quality staff and work to grab market share in times of crisis. Instead, they fire workers and hold prices high to keep cash, profits and their bonuses up.
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If that is the case (and I think it is), there is surely now a risk to margins – because the incentive-based payments that have skewed our economies appear to be all but over.
Most top managers and bankers still think they should be left alone to be paid whatever they and their remuneration committees think right. But what they refuse to understand is that it is too late for that: the genie of popular backlash is out of the bottle, and it isn’t going back in.
Those accused of being overpaid have had ample time to sort out the problem themselves - they just haven’t done it. So it is almost inevitable that, in the UK and very possibly elsewhere, the state is going to end up being forced to become the agent of change.
Over the next few years, if demand destruction doesn’t shrink margins, I strongly suspect that legal restrictions on performance-related pay will start doing the job anyway. It will be part of a shifting of incentives back to where they should be: away from personal super-enrichment, and back to providing long-term shareholder value.
If I were thinking of investing in companies with large cash piles, I’d also keep at the forefront of my mind the fact that we live in a time of big governments – and one in which those governments are all but bust. So the cash that makes companies attractive to me will also be making them attractive to the taxman. You might think governments won’t dare to be anti-business in the face of today’s very low growth; I’d say that is quite something to bet on.
Finally, there is the money-printing/quantitative easing (QE) argument. Defensives are dull; defensives are worthy; and defensives have had a great run. Does that make them the kind of stock you want to hold when the entire world is printing more money than ever before?
I said last year that the European Central Bank (ECB) would have to print a whole pile of money. Now it has. It isn’t calling it quantitative easing, but the ECB's 'long term refinancing operation' has effectively chucked over half a trillion euros into the market.
I also said that when this happened, everything would go up. And so it has. This is a classic cash-driven 'dash for trash' – and one in which the defensives are being left behind. Over the long term, value and income investing are always the way to get rich. In the shorter term, with conditions like this, that isn’t so. Holding defensives as a theme isn’t dead; but, as Ruffer’s Henry Maxey says, it is most certainly “due a good test of nerves”.
• This article was first published in the Financial Times
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