The only certainty in equity markets right now is more uncertainty. So it is no surprise that investors have clamoured for defensive blue-chip stocks with reliable dividend yield.
Companies with monopoly-like assets, such as airports and toll roads, appeal in an increasingly fragile global economy. As does owning dependable dividend stocks in a market where most of the total return in 2016 will come from yield rather than capital growth.
But the defensive/dividend trade has become increasingly crowded. Rising prices for infrastructure stars, such as Sydney Airports and Transurban Group (TCL), leave little room for error, as do valuations for APA Group (APA), AusNet Services (AZI) and other utilities.
The best defence, of course, is identifying exceptional companies and buying them when they trade below their intrinsic or true value. Paying too much for assets – defensive or otherwise – is never a good idea in the long run. Look what happened to investors who overpaid for the big banks and Telstra Corporation (TLS) at their peak, in the quest for yield.
Knowing how to spot “defensive” stocks and not be suckered by labels is critical. Genuine defensive stocks have an “economic moat” or sustainable competitive advantage that is typically reflected in a high, rising Return On Equity (ROE) over time.
Many investors turn to the utilities and infrastructure sectors because their best companies have assets that are hard to replicate and harder for consumers to avoid. Rising population growth and favourable regulatory settings can be significant tailwinds for these sectors.
The top Australian Real Estate Investment Trusts (AREITs) have defensive qualities too. Not that investors would picture the sector as a “defensive” play, after the largesse in the previous decade when AREITs collectively borrowed too much and expanded too aggressively. But income from long-term leases in A-grade buildings is, in theory, less volatile than corporate profits.
Companies don’t always need monopoly assets to have a defendable sustainable advantage. Lifesciences company CSL (CSL) seems an odd choice as a “defensive” stock but its patents, reputation and knowledge are formidable advantages. It has barely missed a beat over the past five years, with an average annualised total return of 26%.
REA Group (REA), too, seems far more cyclical than defensive, given its real-estate exposure. But the “network effect” of its online platform attracting more users, which in turn attracts more advertisers and thus users, is a barrier for competitors and a lure for investors willing to cop REA’s high valuation.
And what of Woolworths? (WOW) For a time, it was supposedly as defensive as it gets because customers always need to eat. Then it tumbled this year, as investors realised even duopolies can be belted and that a disastrous foray into hardware retailing had diminished Woolworths’ defensive qualities at a time when investors craved certainty.
The point is: defensive assets exist across the market, not only in a handful of sectors. Going to the same sources for defensive investments risks joining the “crowd” after the event and overpaying for assets. New options, such as exchange-traded products, can be used to minimise risk, and even certain commodities can play a defensive role in portfolios.
With that in mind, here are five ideas for defensive investors.
1. Consumer staples
Leading consumer-staples companies have valuable defensive qualities: demand for food and other “staples” remains reasonably constant despite economic ups and downs. Sadly, the Australian market lacks large, investment-grade consumer-staples companies. Woolworths and Wesfarmers (WES) have significant discretionary retailing operations in their discount department stores. And Wesfarmers, great company that it is, has a conglomerate model that reaches to the more volatile resource, fertiliser and insurance industries.
Overseas markets provide better exposure to household-name consumer-staples companies. The ASX-quoted iShares Global Consumer Staples ETF is a simple way to expose portfolios to companies, such as Nestle SA, Procter & Gamble and Wal-Mart Stores.
Almost 60% of the ETF is in the global food, beverages and tobacco sector and another 20% is in food and staples retailing. The ETF is unhedged for currency movements, so investors need to be confident the Australian dollar is not about to rally. Further falls in our currency, as I expect this year, would boost returns. The EFT trades on an average trailing Price Earnings (PE) multiple of 21 times. Wesfarmers trades on almost 20 times and Woolworths is on 16.4 times. Paying a slightly higher valuation multiple for exposure to a portfolio of the world’s best consumer-staples companies, which enhances diversification and reduces risks, appeals.
Chart 1: iShares Global Consumer Staples ETF
Source: Yahoo!7 Finance, 18 February 2016
2. AREITs
Macquarie Equities Research compared valuations in the AREIT, infrastructure and utilities sectors in late January. Its conclusion: utilities offer the highest expected dividend yields, infrastructure stocks offer the highest expected total return, and AREITs offer the greatest distribution certainty. Overall, AREITs had the best outlook.
I nominated Westfield Corporation as one of five top stocks to buy during market weakness for the Switzer Super Report in early January, and maintain that view. Westfield has rallied from $9.19 to $9.80 since that report in a falling market.
Westfield’s high exposure to the US economy, which has better prospects than most developed countries, is attractive. Significant rental increases when some of its leases are renewed in 2017 and asset revaluations are other potential re-rating catalysts.
GPT Group (GPT) also appeals. It has a solid balance sheet, reasonable earnings and distribution certainty, and a quality portfolio of commercial properties on Australia’s East Coast. Its long-term leases provide defensive earnings in a volatile market.
The market has mixed views on GPT. Four of eight analysts have a buy recommendation, four a hold and two a sell, consensus analyst estimates show. A median target price of $4.81 suggests GPT is fully valued at the current $4.91.
GTP can do better than the market expects, as investors favour defensive, yield-focused AREITs, and it looks more reasonably valued than its largest peers. It has greater scope to increase rents and decrease costs than most defensive ‘rent collectors’ in the AREIT sector. Recent leadership changes and a new business structure at GPT should provide further impetus in the next few years.
Chart 2: GPT Group
Source: Yahoo!7 Finance, 18 February 2016
3. Infrastructure
Sydney Airport (SYD), a core idea of this column in the past few years, continues to impress. Rising international visitations to Australia and steady growth in domestic travel are strong tailwinds for the airport owner.
Sydney Airport has rallied from about $6 in early January, when I nominated it for this Report as one of five stocks to own in 2016, to $6.40. Current shareholders should hold on; prospective owners might wait for an inevitable price pullback. Sydney Airport is fully priced rather than excessively so given the unfolding boom in Asian tourism to Australia.
Like Sydney Airport, toll-road operator Transurban has fabulous assets and a hefty price tag. It fully owns the CityLink tollway in Melbourne, and fully or partially owns several key roads and tunnels in Sydney, Brisbane and the United States.
Transurban looks well positioned to lift its dividend over the next few years, as growing traffic congestion increases toll-road volumes and as road widening and other strategic initiatives boost earnings. But a high valuation makes it hard to buy at the current price.
Internationally focused toll-road operator Macquarie Atlas Roads Group has more valuation appeal. It has interests in toll roads in France, the United States, Germany and the United Kingdom, and has been a good performer over the past five years.
Macquarie Atlas (MQA) is enjoying solid growth in traffic volumes on most of its roads, and recent concession extensions on the Autoroutes Paris-Rhin-Rhône (APRR) show the potential to increase earnings on the European roads. The APPR, part-owned by Macquarie Atlas, is Europe’s fourth-largest motorway.
A better result from Macquarie Atlas’s US roads, a source of lingering market concern, is another positive. Like Transurban and Sydney Airport, Macquarie Atlas has had a strong rally and it has been volatile over the years. But a forecast PE of 16 times, using consensus estimates, compares favourably with its larger infrastructure peers.
Chart 3: Macquarie Atlas Roads Group
Source: Yahoo!7 Finance, 18 February 2016
4. Utilities
Telstra Corporation, the king of defensive dividend stocks in recent years, looks more interesting after falling from a 52-week high of $6.66 to $5.44.
With Sydney Airport and Westfield Corporation, Telstra was nominated in January (at $5.30) for the Switzer Super Report as one of five stocks to buy during market volatility.
Telstra’s superior mobile network and the scale derived from its market share and infrastructure are a formidable economic moat for competitors. Rising competition in mobile telephony is a concern, but few stocks can match its defensive qualities.
Telstra is approaching value territory. At $5.44, it trades on a forecast PE of 15.5 times using consensus estimates, and has an expected grossed-up dividend yield of about 8% (after franking). The market is concerned about Telstra’s dividend sustainability, but it has more dividend appeal than the big-four banks in the next few years.
Chart 4: Telstra Corporation
Source: Yahoo!7 Finance, 18 February 2016
5. Gold
Investors who have dabbled in gold equities might regard the precious metal as the opposite of defensive investing. Gold equities, collectively, have badly underperformed the market over five years and have had a knack of destroying wealth.
From an asset-allocation perspective, gold bullion has useful defensive qualities and a role in portfolios. Income investors should stop reading now because gold offers no yield. For those in the asset-accumulation phase, an allocation of up to 5% of portfolios (less when risk appetite returns) to gold can act as a form of insurance in a financial-markets storm.
Gold’s safe-haven qualities have come to the fore this year as equity-market volatility has driven the precious metal and gold equities higher. China’s devaluation of the Yuan and an intensifying global currency war reminded investors of gold’s traditional role as a store of value. Signs that rises in US interest rates and the Greenback could be more gradual than previously thought also buoyed the gold sector.
I see the Australian-dollar gold price heading higher in 2016, albeit with a few setbacks along the way. It is due for a bigger price pullback after such strong gains in 2016, and that could present a buying opportunity for long-term investors. Portfolio investors who want pure exposure to gold should favour bullion over gold equities, which add company and market risks.
The ANZ ETFS Physical Gold ETF is a simple way to add gold to portfolios. Bought and sold like a share on the ASX, it is exposed to the US-dollar gold price so investors need to form a view on the currency. Those who prefer to eliminate currency risk could use the BetaShares Gold – Currency Hedged ETF.
Chart 5: ANZ ETFS Physical Gold ETF
Source: Yahoo!7 Finance, 18 February 2016
• Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at 17 February 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
