The return of relative value to defensive stocks

For most of the post-crisis period, defensive stocks have been expensive. Russ suggests that may have changed.

Recently, classic defensive stocks such as consumer staples and utilities have not lived up to their reputation. U.S. stocks are flat year-to-date and have experienced a meaningful increase in volatility, but defensive stocks have offered little protection: Utilities and staples are down 4.5% and 8.5% respectively year-to-date.

To some extent, weakness in these two sectors makes sense. Both are classic dividend plays, and accordingly sensitive to higher rates. As the yield on the 10-year Treasury has climbed towards 3%—a four-year high—you would expect these sectors to under-perform. However, the magnitude of the under-performance is worth noting. Given how much these sectors have trailed the broader market, for the first time in years valuations are starting to look reasonable.

Re-rated

Low beta companies, i.e. those less risky than the market at large, particularly those owned primarily for their dividends, have generally been sensitive to interest rates. As bond yields rise, investors are less incentivized to own a dividend paying stock versus a safer bond. This is why the relative valuations of these stocks tend to fall as rates rise.

This relationship has grown even stronger in the post-crisis, yield starved environment. Since 2010, the level of the 10-year Treasury yield has explained approximately 45% of the variation in the relative valuation–defined as the valuation of the sector versus the broader market–for the utilities sector. For the consumer staples sector the relationship explains approximately 63% (see Chart). This relationship goes a long way towards explaining why both sectors have performed so poorly of late.defensive_vs_ratesFinal

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However, given the degree of the recent under-performance, for the first time in a long time both sectors are starting to look reasonably priced. U.S. utility stocks trade at approximately a 20% discount to the market. Based on the historical relationship between rates and relative multiples, this looks about right. In contrast, for much of the post-crisis environment utility companies looked perpetually over-priced.

Staples evidence a similar pattern. Large-cap consumer staples companies are trading at an 11% discount to the S&P 500.  This represents the cheapest relative valuation the sector has possessed since 2010. More interestingly, even after adjusting for the recent backup in rates, staples appear on the cheap side. The sector is trading at around an 8% discount to what long-term rates would suggest is fair value. While not a particularly large discount, it has been years since the sector appeared under- valued based on this metric.

Obviously, other factors matter; recent weakness is not simply a function of interest rates. In the case of consumer staples, declining brand value and the fragmentation of the consumer space have contributed to the sector’s under-performance.

That said, given higher volatility and justifiable concerns about lofty market multiples, investors can be forgiven for exercising some caution with their portfolios. Interestingly, just as investors are rediscovering the value of playing defense, one of the classic ways to play that theme is starting to look more reasonable.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

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