Focus on defensive ‘bond proxy’ stocks is no longer a risk-averse strategy as valuations climb argues Royce & Associates

2nd July 2013


Focusing on defensive companies no longer represents a risk-averse strategy in today’s markets, argues mall cap specialist fund manager Royce & Associates

Frank Gannon, portfolio manager and principal says investors need to resume viewing and analysing stocks as businesses rather than just seeking the lowest-risk defensive names as an alternative to bonds.

“The ongoing effects of anaemic global economic growth continue to play out, with corporations struggling
to generate top-line growth and investors to find yield. Yet one has to wonder if it is time for investors to resume viewing stocks as businesses and not as surrogates for riskless bonds in a slow-growth world.”

For the fourth year in a row, global growth doubts emerged at the end of the first quarter, with the Russell 2000 index (small cap index of US stocks) correcting more than 5% from March to mid-April before regaining most of this as the month progressed.

With growth concerns on the rise again, Gannon says the ongoing outperformance of defensive ‘bond-proxy’ equities at the expense of more cyclical sectors is no surprise.

“After gaining 26.6% in 2012, Real Estate Investment Trusts (Reits) in the Russell 2000 were up another 18.8% over the first four months of the year while utilities advanced 14.8%. From our perspective however, being risk averse in today’s market is not necessarily risk averse: chasing yield in defensive sectors and searching for risk-free returns carries increased valuation risk and is one of the effects of the no-growth world in which we live.”

According to Gannon, the paradox of such an environment is that it should focus investors on better businesses with
the financial and operating strength to thrive in an uncertain world. “That said, the idea rates will remain low indefinitely has permeated the investment landscape at the precise moment the credit re-rating of riskier corporations is behind us,” he says.

“Our preference has always been to focus on business risk with an eye toward valuation. Our analysis
has concentrated on free cashflow yield as an important metric in determining a company’s absolute valuation. We have always thought free cashflow generation is linked to a stock’s ability to sustain positive revenue growth and
produce high internal rates of return.

“With the flexibility of excess free cashflow, companies can focus on effective capital allocation, which includes capital expenditures, buybacks, debt repayment, and even dividends. This is of paramount importance in today’s low-growth environment as corporations struggle
to generate top-line growth.”

According to Royce, prudent capital allocation should be the catalyst to a powerful investment cycle once the fog of anaemic economic growth
and near zero interest rates lifts.

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