Cautious investors can still find good value defensive equities, according to Fidelity’s Alex Wright, who says they should dip down the market-cap spectrum instead of piling into mega-cap ‘bond proxy’ stocks such as consumer staples and utilities. 
There have been growing concerns about the outlook for defensive mega-cap dividend-paying equities as traditional fixed income investors, who have been forced out of the bond market by QE and ultra-low interest rates from the world’s central banks, have pushed up their valuations in order to find less-risky assets.
As valuations are now high by historical standards, certain fund managers have warned that the likes of consumer staples and utilities are due a period of sustained outperformance as they are now closely correlated to the bonds – which are expected to fall in value over the coming years as interest rates start to rise.
These bond proxy stocks have certainly been a profitable area of the market. FE data shows, for example, that the MSCI AC World Consumer Staples index has massively outperformed against the all-encompassing MSCI AC World index over the past seven years.
Performance of indices over 7yrs
Source: FE Analytics
On top of that, funds with a high weighting to defensive equities such as CF Lindsell Train UK Equity, Invesco Perpetual High Income and Fundsmith Equity have all outperformed significantly over recent years as a result.
FE Alpha Manager Wright, who heads up the five crown-rated Fidelity Special Situations fund, agrees that the outlook for these stocks looks very poor. However, he says investors don’t necessarily have to rush into more risky areas of the market because of it.
“In terms of defensive type stocks, I’m very much shying away from some of the traditional areas such as staples and utilities. I think these are expensive and well-liked areas of the market with very little potential for any positive change,” Wright (pictured) said.
“But I do think if you go down the market-cap spectrum, you can find value and companies that have both defensive earnings but also the potential for growth.”
One of the major reasons why Wright is avoiding large-cap defensive equities is due to their increasing correlation to the bond market.
While prices have now stabilised, as a result of improving economic data, a kick-back against negative rates and a lack of underlying liquidity, yields on developed market government bonds rose substantially between February and the end of May and caused large drawdowns for investors.
Wright points out that the performance of shares in Unilever, the multinational consumer goods company, has been tightly correlated to the performance of US treasuries and, as the graph below shows, FE data backs up his argument.
The graph plots the performance of the Barclays Global Treasury Index versus Unilever since yields on US government bonds started to rise in early February.
Performance of stock and index since Feb 2015
Source: FE Analytics
Many warn that, with the US Federal Reserve likely to raise rates before the end of the year, there will be another bond market sell-off in the not-too-distant future.
“Effectively, investors who have traditionally been bond investors have been forced to chase risk and move into high risk assets such as large-cap defensive equities and therefore they are being bid up to very high levels,” Wright explained.
“You have the likes of Unilever, which is trading on 20 times earnings. Effectively, I think there is very little value or very little underappreciated potential for change in the staples or utility areas of the market. Therefore I’m not investing there and I am very underweight.”
There are a number of experts who disagree with Wright’s views, however. One of which is FE Alpha Manager Nick Train, who counts Unilever as his largest holding in his fund as it makes up 9.4 per cent of his assets.
He recently told FE Trustnet that there are two distinct caveats with the argument that the likes of Unilever are set for a rough ride in the medium term.
“First, if a share is really a bond proxy it must have qualities similar to a bond. The most notable characteristic of a conventional government bond is that it has a fixed, unchanging coupon. But our holdings most often cited in this context – Diageo, Heineken, Unilever – do not have fixed dividends.”
"They have, instead, long histories of real, inflation-beating dividend growth and, in our opinion, plenty of scope to maintain these records. If there is anything ‘bond-like’ about such companies, then actually the bonds they most closely resemble are index-linked government bonds, not conventionals.”
“Second, history also teaches that the type of companies that suffer most operational damage during periods of rising inflation are capital intensive suppliers of commodity products.”
Nevertheless, FE Alpha Manager Henry Dixon – manager of GLG Undervalued Assets – says investors could be looking at 20 per cent downside in these types of bond proxies.
“Bond yields could rise from the lows of 1.5 and potentially double because of inflation data that we could get in December/January. It would then follow that shares that have enjoyed ratings of 25-30 times could see five of their P/E points disappear very quickly.”
Most experts now advocate buying more cyclical companies as not only are they cheaper, but they tend to perform better in a rising yield environment.
However, while Wright’s fund is more economically sensitive than most, he says cautious investors can still find companies with reliable earnings and a safe and strong dividend, without having to over-pay for those characteristics.
“I have been going down the market-cap spectrum into some still quite high yielding prospects. Stocks such as Homeserve, Phoenix, Vitec, McColl’s Retail and KCOM all have yields over 4 per cent and also the potential for growth – particularly in the shape of Homeserve, which has a very high growth US business and is also growing across Europe as well as the steady underlying core in the UK.”
He added: “I think there is still value in some of the defensive areas of the market, but you have to search a bit harder and further down the market cap spectrum to find it.”
Homeserve, the FTSE 250-listed home emergency repairs business, has a yield of 6 per cent and has massively outperformed its index over the past 12 months with returns of 31.45 per cent. It is Wright’s 10th largest holding and makes up 2.2 per cent of his fund.
Wright is the best performing FE Alpha Manager of three, five and seven years as a result of his time on Fidelity UK Smaller Companies fund. He took charge of his Special Sits fund in January 2014, over which time it has outperformed against the IA UK All Companies sector and the FTSE All Share.
Performance of fund versus sector and index since Jan 2014
Source: FE Analytics
The fund did have a tough time in 2014 as it was bottom quartile with losses of 1.6 per cent as Wright’s value/contrarian style and bias towards mid and small-caps fell out of favour. However, it is top decile so far in 2015.
Fidelity Special Situations has a clean ongoing charges figure of 0.94 per cent.
