Equity market players are banking on strong defensive action and are buying supposedly boring companies instead of fast-growing stocks. This could be seen in October when the until-then popular technology stocks chalked up heavy share price losses while the previously-shunned defensive stocks caught up. Prices of shares from the pharmaceuticals and food sectors are currently charting highs for the year while the prices of cyclical stocks are far lower.
In theory, the well-being of cyclical stocks depends on an environment of economic growth. In an economic recession their share prices accordingly fall more than the average. By contrast, defensive stocks also prosper when the economy weakens. In practice, however, for several years now companies such as Nestlé, AB Inbev, Coca Cola and Co. have been growing far more slowly (if at all) than global inflation. These defensive companies have increasingly sought salvation in financial engineering measures. These have included share buy-backs and dividend payments, which – thanks to low interest rates – were in some cases funded by loans. As a result of buy-back programmes, earnings per share increased despite stagnating business. However, at the latest since 2018 when several emerging markets showed signs of weakness, it has been hard to hide vulnerabilities in the core business. This was to be seen in the profits warning from the brewer AB Inbev at the end of October, which led to dividend payments being cut in half.
It is all the more surprising that the pendulum has now swung back so far in favour of defensive stocks. Today, the strength of defensive stock prices and the simultaneous weakness of cyclical stock prices has led to surprising valuation constellations: For example, the share of “Campbell Soup” is currently trading in the equity market with a P/E of 16.1 for 2019. This makes it one of the cheapest stocks in the defensive segment, as many shares in the food industry also have P/Es beyond the 20 mark. Campbell Soup is world market-leader in the instant soups segment (e.g. “Erasco”) – a segment that has stood out in the past neither for innovations nor for growth. The P/E of Campbell Soup is thus on a par with the cash-adjusted P/E of the company Alphabet (16.3). Along with Google, Alphabet is world market-leader for digital advertising, world market-leader for smartphone operating systems and one of the leading companies in the areas of artificial intelligence and cloud computing. Bloomberg estimates long-term sales revenue growth over the next five years at 18% per year for Alphabet and 3.5% for Campbell Soup. The rule of thumb “growth at a reasonable price” can be used to relate the current P/E to expected long-term growth. Accordingly, Alphabet is attractively valued, whereas Campbell Soup is very expensive.
Ever more investors are apparently afraid that the world economy is losing momentum and are, therefore, selling off those stocks that benefit from strong economic growth. But in our view if more emerging markets and their currencies were to slip into crisis, then the defensive companies, which have also expanded greatly in these countries, would not offer much more safety than the market as a whole. In addition, investors are missing opportunities in the technology sector, in which more disruptive energy is being unleashed at the moment than at any time since the industrial revolution. What’s more their shares (see Alphabet/Google) are not too highly valued just as the broad equity market valuation of the S&P 500 has recently settled down again at a price-earnings ratio of 16.2. So it is within the fair historical range.
In light of the prevailing uncertainty this trend towards defensive stocks should continue for some time to come. There is, however, much to suggest that the faster-growing stocks will soon become more popular again. This will probably be the case at the latest when the leading economic indicators’ current weakness is over.