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Global defensive equities

Defence in depth: building a more resilient portfolio

August 2018

Laurent Nguyen, Head of Global Defensive Equities, Gabriele Susinno, Senior Client Portfolio Manager

Deploying multiple lines of defence can help investors build a truly resilient portfolio of stocks.

Stone walls, towers, moats and heavy wooden portcullises. Medieval monarchs and lords certainly knew how to build strong defences. They successfully deployed several different types of fortification to protect their wealth.

The investment community could learn a thing or two from the nobles of the middle ages. While most investors appreciate that protecting capital during the bad times can lead to better returns over the long run, few understand what it takes to build a genuinely resilient portfolio of stocks.

In fact, many of the conservative equity strategies currently popular with investors have the same glaring vulnerability – they rely on just one line of defence.

Take for example “low volatility” equity – one of the fastest-growing strategies.

Funds that are referenced to the MSCI Minimum Volatility Index often invest in companies that pay high dividends in sectors such as utilities, staples or real estate. These firms are considered stable investments also because they often behave like coupon-paying bonds.

Investing in low volatility strategies has worked well in recent years as bond yields have hit historic lows. However, as interest rates begin to rise, that could change. That’s because most companies in these indices have consistently increased debt to fund dividends and share buybacks, weakening their balance sheets (see chart). That could store up trouble for funds invested exclusively in low-volatility stocks. 

borrowing trouble?

Cumulative debt (in USD bln) since 1998 of low volatility companies and top quartile 4P companies, ex-financials

Cumulative debt of low volatility and top quartile companies
Top 4P companies are those which rank in the top quartile in GDE's 4P (Profitability, Protection, Prudence, Price) investment screen. Low volatility companies are those in the top quartile of our Protection screen. Source: Pictet Asset Management, data covering period 31.12.1997 - 31.12.2017

Investing in funds that target “quality” stocks is another popular approach. Such strategies commonly use analytical metrics to identify a group of companies that are profitable, have low leverage and whose earnings have historically been very stable. 

However, by focusing on the present level of a company’s earnings and not taking into account stock valuations, these strategies tend to have a large bias towards US tech stocks – the major contributor of the recent equity rally – and a large underweight position in financials (see chart).

Tech is the most expensive sector. And it is one whose companies are vulnerable to both tighter regulation and changes in consumer behaviour. What is more, quality stock strategies’ underweight stance in financial stocks may backfire in the era of rising interest rates as bank lending margins tend to rise when base rates head higher. 

Exposed

Active sector weights relative to MSCI World Index

Active sector weight vs MSCI World
Source: MSCI, Bloomberg, Pictet Asset Management, data as of 31.07.2018

As these examples show, conservative equity funds that focus on a single defensive factor expose investors to risks.

Not only do single factor strategies concentrate investments in overpriced stocks, they are also not flexible enough to adapt to sudden shifts in macroeconomic conditions, such as higher interest rates.

As a result, they can suffer disproportionate losses when markets turn sour.

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.