As the global economy slows, investors are scurrying to find stocks that can thrive in tougher times. The problem they face is that many defensive stocks have now soared to levels that undercut their appeal as havens.
Consider Costco Wholesale Corp., purveyor of humongous packs of household goods. Costco is a company that soldiers through recessions because its fundamental sales pitch – buy in bulk to save money – works just as well in slowdowns as in boom times.
The challenge for investors today is that everyone recognizes the company’s many virtues. Since the start of the year, Costco shares have soared 44 per cent. Its stock now trades for more than 35 times the company’s earnings per share, which is the kind of lofty ratio usually associated with high tech disrupters, not discount retailers.
Other defensive stocks have enjoyed a similar lift in similar months. As recession fears rise, companies with boring but predictable businesses have become the market’s darlings, supplanting some of the technology giants that monopolized investors’ attention in previous years.
The shift in fortunes is striking. In the United States, shares of Amazon.com Inc., Netflix Inc. and Google’s parent, Alphabet Inc., have all performed worse than the S&P 500 Index since January. In contrast, Walmart Inc. has shot up 27 per cent while Procter & Gamble Co. has rocketed ahead 33 per cent, easily beating the 16-per-cent gain in the broader market.
In Canada, some of this year’s biggest winners have been utilities Hydro One Ltd. (up 23 per cent) and Fortis Inc. (up 24 per cent), as well as discounter Dollarama Inc. (up 44 per cent).
At this point, none of these supposed havens looks cheap. For investors who want to play defence, this means a shift in thinking may be required.
During past recessions, it was possible to prosper by shifting out of economically sensitive sectors and into businesses that could increase their earnings – or at least sustain them – despite slowing business activity. In general, that meant cash-rich companies with dependable sales not tied to the economic cycle.
Power utilities, oil pipelines, real estate investment trusts (REITs) and purveyors of consumer staples were the type of reliable businesses that performed well during previous downturns. This time around, though, investors have to ask whether they are paying too much for the supposed reliability of these sectors.
Three of the biggest U.S. consumer-staples stocks – Procter & Gamble, Coca-Cola Co. and Colgate-Palmolive Co. – each trade for more than 25 times earnings, an exceptionally high level for such big, mature businesses. In Canada, most utilities and railways look fully valued, while REITs appear distinctly pricey after their big run-up in recent months.
So where can investors now go in search of shelter? One notion is to look for exchange-traded funds (ETFs) that hold an assortment of stocks picked for their relatively low levels of volatility. Academics say such deliberately boring stocks have tended in the past to produce better risk-adjusted returns than their more exciting cousins.
At the very least, a minimum-volatility ETF gives you a one-stop way to buy a diversified assortment of stocks selected for their stabilizing properties. Bank of Montreal, Vanguard Canada, CI First Asset and iShares (the ETF arm of BlackRock Inc.) are among the companies offering minimum-volatility ETFs. While none of the individual stocks in these ETFs may be particularly cheap by itself, as a group they offer one way to dial down your risk while staying in the market.
A slightly more adventurous approach is to look for companies that are not defensive in traditional terms, but that still possess haven-like qualities. One possibility is Berkshire Hathaway Inc. Warren Buffett’s flagship company is widely diversified and it boasts a cash stockpile of more than US$120-billion. If the global economy does tank, Berkshire could use that cash to scoop up bargains.
Alphabet is another company that seems well positioned for whatever might come. Even in a recession, people will still use Google. And with next to no debt, and an impressive ability to spin off cash, Alphabet can sail through any short-term distress.
Finally, investors may want to consider the possibility that any downturn will be mild and transient. If so, the place to be right now is not in defensive stocks but in beaten-up areas, such as energy and mining stocks. They are the furthest thing from defensive plays, but if the future turns out to be brighter than most people now expect, these highly cyclical stocks will do well for patient investors.