The textbook definition for defensive companies is that they are those that tend to outperform the general market when economic growth slows. They provide more consistent free cashflow and stable earnings growth profiles regardless of the state of the overall market or economy and as there is a constant demand for their products, they also tend to be more stable during the various phases of the business cycle. They are great places in which to invest when the economic outlook is slowing down, contracting or turning sour.
Property companies, healthcare companies and manufacturers of alcoholic beverages and tobacco (to name a few) are traditionally viewed as part of the defensive companies club – given their historic ability to deliver consistent volumes and cashflow.
Every crisis in financial markets has different winners and losers. The arrival of COVID-19 turned the traditional defensive plays on their head. Hospital capacity and availability were at the forefront of why country lockdowns were needed. Alcohol is viewed as a risk to the availability of hospital capacity, leading to a second round of sales banning as infection rates soared. As governments announced lockdown regulations, property companies suddenly had to renegotiate with distressed tenants as footfall, office usage and manufacturing went to near zero, which created risks around the sustainability and defensiveness of their cashflow.
Some of the traditional defensive companies were suddenly in unknown territory. The share prices of some listed property companies are still down about 50% year to date, hospital counters around 30% down and Anheuser-Busch InBev is down just over 20% for the year relative to the overall market, which has recovered to flat for the year to date.
COVID-19 has introduced new themes to the market. ‘Work-from-home’ sectors (Tech and digital, Data service providers) have seen almost no disruption in their activities and are even flourishing in the current environment. Other sectors will face a longer period of recovery (Travel and Tourism, Hotels and Entertainment). The strength and pace of recovery for different industries and sectors will be dependent on the rate of ‘normalisation’ of consumer and corporate behaviour and to what extent policy interventions would be able to assist in the pace of recovery.
Supply and demand dynamics in the Resources sector also played out “more defensively” than expected for a sector usually seen as more cyclical. Less geared and safer balance sheets helped the resources companies going into this crisis. The demand disruption for commodities was countered by supply disruptions (less supply due to lockdowns), which meant that a lot of commodities were still in a well-balanced supply-demand dynamic, which supported the commodity prices. As lockdowns started in the East and moved to the West there was also a mismatch between supply and demand created for certain commodities. The exception to this was oil, where the shock to demand was not met by the same slower supply. Geo-political differences at OPEC+ caused the June 2020 Oil futures contract to trade at a negative value right in the middle of the COVID-19 chaos.
While we believe social distancing will largely fade over time (as people are social beings), consumer and business activity will have a greater online focus. The acceleration in growth we have seen in online trading over the last three months is equivalent to growth expected to take five to eight years – it has accelerated the online strategy dramatically. We also believe companies will focus on reducing leverage, improving liquidity and building resilience by diversifying supply chains (a greater shift to “Just in Time”, where companies try to minimise inventory costs by producing the goods after the orders have come in, versus “Just in Case”, in which companies stockpile inventory or support local suppliers).
We believe longer-term structural changes over the coming years are likely to be accelerated by the arrival of COVID-19 such as:
- Greater focus on health;
- Preference for well-known and trusted brands;
- Deteriorating fiscal positions following stimulatory emergency policies could pave the way for increases in policies to improve revenues of governments across the world (i.e. higher taxes);
- A shift in individual and corporate behaviour from ‘leverage’ to ‘savings’, which is a typical reaction to improve resilience following periods of harsh economic conditions;
- While excess capital has been employed for share buybacks by corporates across the world over recent years, we believe going forward any excess capital will be utilised for capital expenditure programmes in an effort to diversify supply chains.
In this new world where new rules apply, our preferred exposure in the Ninety One Equity Fund remains to the general miners and platinum group metal miners, which is well balanced with our large exposure to Gold and rand-hedge defensive stocks such as Naspers and Prosus. These stocks’ stable earnings expectations are attractive on relative basis and have consistently delivered through these volatile markets. In South Africa, our exposure remains with the banks (predominantly FirstRand and Capitec) and other select counters, such as Sanlam and The Foschini Group.
We believe it is paramount for us not to deviate from our disciplined investment process: allocating to stocks with positive earnings revisions at a reasonable valuation. In an environment of broad-based negative earnings revisions, the ability to find corporates receiving overly bearish expectations presents an investment opportunity to take advantage of, as it leads to mispriced valuations. DM