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As we’ve written recently, the defensive equity factors that would typically have been expected to outperform during last year’s COVID-driven drawdown disappointed doubly — barely mitigating on the way down and significantly lagging during the rebound. But today we think the fundamental setup for defensive factors is as attractive as it’s been in over a decade.
How did we get here?
It wasn’t long ago that defensive factors like low beta were all anyone wanted to talk about. It started with the momentum rollover in the fourth quarter of 2018. At the time, there was record-low unemployment, strong GDP growth, and low inflation. Then worries about a US-China trade war and Federal Reserve rate hikes sparked a mini flight to safety. By the time the fourth quarter ended, US markets were down 14% and the low-beta factor had outperformed by 12% — by far the best performance among our core proprietary factors.1 One would generally expect low beta to outperform in a down market, but the extent of outperformance was unprecedented. That was followed by another surprise: In 2019 and January 2020, low beta (and defensive factors generally) kept pace with the broader market during a period of double‐digit returns.
It’s easy to see why many allocators moved more heavily into defensive areas leading up to the market peak in January 2020. They were focused on the fact that defensives had done well amid the continued underperformance of value and the long run of growth leadership. They were, however, not focused on the fundamentals.
Figure 1 compares the fundamentals of the low-beta factor before the 2018 rotation (five-year median) to the fundamentals just before the COVID drawdown (January 2020). There are several signs of deteriorating fundamentals and increasing risk. For example, relative profitability (cash-flow return on investment or CFROI) was nearly eight percentage points less than the market (historically speaking, we’d expect it to be roughly in line with the market) and relative valuation (EPS yield) had degraded versus its own history. Importantly, the factor’s defensive characteristics were at an extreme, with a predicted beta of 0.29 to the market, and duration sensitivity was especially high (demonstrated by the rate-rise column, which looks at the expected excess return given a one-standard-deviation move in long-term rates).
Sector weights in the low-beta factor provide some insight on what was driving these extremes: The factor was much less diversified than in the past, with a 75% weighting in utilities and real estate (essentially a pure bond proxy). There were anecdotal signs of exuberance as well, including a doubling of assets in minimum-volatility and low-volatility ETFs between January 2019 and January 2020.
Where is the opportunity moving forward?
With this fundamental backdrop, it is not surprising that defensive factors fared poorly during the 2020 drawdown and subsequent rebound. But looking forward, we see a potentially attractive entry point for allocators. As shown in Figure 2, low beta is back to normal ranges from a risk perspective. More importantly, it looks as attractive as it has in a while from a fundamental perspective — with market-like profitability and strong valuation support (it is rare for defensive segments to have a higher relative earnings yield). In addition, the extreme sector concentration has abated, with utilities and real estate reduced considerably and sectors such as health care and staples regaining the larger weights that are more typical.
Moreover, we see a lot of apathy around defensive factors, with the market largely focused on two segments: companies with the potential to do well in a reopening and those that have high expected growth and are perceived to be structural winners even without the tailwind of COVID-induced trends. Often, there can be opportunities in apathy.
Beyond low beta: A look at the “profit-stability” factor
While price-based defensive factors such as low beta can help illustrate factor behavior in the market, we focus on more fundamental factors. One example from our proprietary library is profit stability, a factor focused on stable levels of total profit generated over a full operating cycle (10 years). While profit stability benefited somewhat from being lower beta during the first quarter of the 2020 downturn, that benefit was easily overwhelmed by the drag during the rest of 2020 as markets accelerated. But the factor’s profile stabilized in the first quarter of 2021 as we saw signs that fundamentals were becoming more important to performance.
Looking through that fundamental lens, we see the same positives as we did with the low-beta factor. The profit-stability factor is at a 20-year extreme in relative cheapness (Figure 3), based on the market-implied discount rate (the discount rate implied by a discounted-cash-flow model to justify the current value of a stock). Values greater than zero indicate that the factor is cheaper than the market and values less than zero indicate that it is more expensive. During the quantitative easing period (2009 – 2015), implied discount rates fell for the broader market but fell more for stable companies, implying that they were getting more expensive. One possible explanation is that as QE drove rates down during this period, it drove investors out of fixed income and into more bond‐like equities, putting a premium on them. This spread stabilized when rates settled into more of a range‐bound state from 2015 to 2019. As rates moved lower during the pandemic, more bond-like equities became cheaper, not more expensive as intuition would imply, and now the profit-stability factor has an implied discount rate similar to the broader market, which we view as an opportunity.
We think the driver of attractive valuations in the profit-stability factor is apathy. Again, the market has been oscillating between optimism about reopening and pessimism about the vaccine rollout and new strains of the virus. Stable companies don’t feature prominently in either the reopening trade or the COVID-beneficiary trade. They are not the flashy growth names that capture the imagination of a new world with unlimited potential — they will instead tend to be steady businesses with stable competitive advantages and strong profits.
We know that some believe the relative valuation of these companies is a mirage created by the impact of megacap tech stocks. But if we look at consumer staples as an example, since they tend to be at the center of the stability debate, we find that the relative attractiveness does not materially change if we exclude the high growers (Figure 4). They are not just “relatively cheap” because market valuations are high and they have been left behind.
While growth and value may still grab the headlines for a while, we think it’s likely that in the not‐too-distant future we’ll see renewed interest in defensive factors given the evolution that’s taken place in fundamentals against a backdrop of apathy.
1Source: Wellington, MSCI, FactSet. Low beta is a proprietary factor representing the bottom decile of names, with respect to beta, in the MSCI USA Index. Additional information on this data is available upon request. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND AN INVESTMENT CAN LOSE VALUE.
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