The many faces of defence
To minimise these risks, our strategy focuses on four key determinants of defensiveness – profitability, prudence, protection and price – what we call our “4P” framework.
The Profitability factor is our gauge of a business's strengths and competitive advantage. Companies that rank highly on this measure have, among other things, steady earnings growth, low operational leverage and high cash generation. Our research shows that firms with a strong track record of profitability tend to have more reliable and predictable earnings than firms whose stock valuations are in part based on lofty expectations for profit growth.
Prudence is the factor that captures a company’s operational and financial risks. In our framework, prudent firms are those that exhibit a lower risk of default and expand organically rather than through acquisitions. We invest in businesses that can create and preserve shareholder value by pursuing manageable growth and maintaining a sound financial profile. We measure this by looking at the nature and stability of the company’s cash flows relative to its financial commitments, including interest, dividends or capital spending.
Our Protection metrics monitor how a firm behaves over the course of the economic cycle – the aim is to quantify systematic or company-specific risks. We are looking for companies that have sustainable business models and whose prospects are insensitive to shifts in economic cycles. At the same time, we also analyse a stock’s volatility and its correlation with other equities to understand how it might affect the risk-return profile of the overall portfolio.
Finally, we don’t want to overpay for our investments. Therefore, our Price screen incorporates several reliable valuation models that help us identify the most attractively-priced stocks. Without this screen, portfolio managers could overlook promising investments or choose stocks that risk a capital loss.
As a result of this comprehensive approach, our portfolio has a defensive profile that encompasses large cap, quality, value and low volatility stocks. Each of our four Ps represents a single line of defence that, when combined, produce an equity portfolio that is better able to withstand market shocks.
Preserving capital with a multi-dimensional defensive approach is key to securing healthy returns over the long run.
Adapting to the changing nature
What is more, our 4P approach is dynamic, not static as many smart beta strategies tend to be.
Our starting point is to evenly weight all the 4Ps when we screen stocks. We then change that allocation, basing our decisions on an analysis of economic and market trends and the momentum and valuation of each P.
For example, we’ve been underweight the Protection factor in the past two years, because stocks ranking high in this score – many of which are equities that behave very much like bonds – tend to struggle at a time when the US Federal Reserve is raising interest rates. In addition, our analysis showed that valuations for stocks which score strongly on Protection wasn’t attractive compared with those represented in the MSCI World equity index.1
However, in the most recent reweighting of 4Ps, we’ve decreased our underweight stance on stocks which score highest on Protection to 5 per cent from 10 per cent, because their average valuation relative to the MSCI World stock index has fallen below the average of the past 30 years.2
We continue to prefer companies that rank best according to the Price metric, most of which are from industry sectors such as consumer staples, financials and industrials – a universe characterised by high quality and resilient corporate profits. Our overweight stance in the Price metric stands at 5 per cent.
We believe our multi-dimensional approach, combined with the dynamic adjustment, provides a sound basis upon which we are able to build portfolios that are neither over- nor under-exposed to any one defensive factor. Preserving capital in this way is key to securing healthy returns over the long run.
As the lords and nobles of the Middle Ages would tell you, it’s crucial to have more than one line of defence.