As he matured, his ability to judge when to go for the big shot improved markedly but not to the detriment of his defensive skills which remained among the best in the sport.In a much less exhausting fashion, investors must display similar aptitude in knowing when to attack and when to defend. In recent months, cyclical sectors have underperformed defensives - a trend which has caught out many fund managers who would have been better served just keeping the ball in play as opposed to aiming for the lines.
The reasons defensive sectors are en vogue are easily identifiable. Despite a relatively strong domestic economic performance, UK equities have been buffeted by a smorgasbord of negative news. A stagnant eurozone and slowing growth in China alongside various disturbing geopolitical developments (Ukraine, ISIS, Ebola) have harried investors towards the door marked ‘risk-off’.
Stocks in the healthcare, utilities, tobacco, and consumer staples sectors have been the beneficiaries. Valuations, however, are starting to become rather stretched.
While Reckitt Benckiser, the manufacturer of a range of household consumer goods, has many strong brands we find it hard to justify the stock’s current rating. Consensus earnings forecasts for the company have declined steadily throughout the year, yet the stock has re-rated to a prospective PE of c.19x – a multi-year high.
Reckitt Benckiser is far from anomalous; similar arguments could be made for the likes of Unilever, brewers, or the tobacco stocks.
In an economic environment which, at present, is characterised by stagnant demand in developed markets and weakening volume growth in developing regions – it is difficult to see why we should expect any turnaround in the disappointing operating performance exhibited by many stocks in these sectors over the past few months.
Performance of stocks vs index over 7yrs
Source: FE Analytics
Cyclical stocks, by contrast, have suffered from both weakening earnings and investor de-rating.
GKN, a UK industrial exposed to global automotive and aerospace demand, has de-rated by almost 4 turns in recent months despite operational performance which has been reasonably robust.
Sterling strength, a material headwind for UK industrial stocks, has been the most significant contributor to earnings downgrades.
Bodycote, a world-leading thermal processing company, has declined by around 25 per cent from its peak earlier in the year while earnings forecasts are only down marginally.
While the near-term outlook for many cyclical stocks is challenging, investors must decide at what point these risks are fully reflected in valuations.
Performance of stocks vs index over 7yrs
Source: FE Analytics
The recent QE expansion announced by the governor of the Bank of Japan has placed Mario Draghi, his ECB counterpart, in a difficult situation.
A weakening yen versus the euro does little to assist efforts to revive the moribund Eurozone economy. While the practicalities of Eurozone QE remain difficult, we believe it will be the eventual outturn. If this scenario comes to fruition, cyclicals should benefit most. In any sport, situational awareness is paramount.
The ability to successfully adapt an individual or team’s approach to prevailing circumstances can make the difference between lifting trophies and going home early. In a period of elevated volatility and uncertainty, reducing the unforced error count is vital.
With valuations dispersions at elevated levels, however, we think that investors can afford to creep back towards the baseline and swing a little more freely.
Neil Veitch is manager of SVM’s UK Opportunities fund. The views expressed above are his own.
