How Covid-19 has turned defensive companies on their heads

The textbook definition for defensive companies is that they are those that tend to outperform the general market when economic growth slows. They provide more consistent free cash flow and stable earnings growth profiles regardless of the state of the overall market or economy.

There is a constant demand for their products and they also tend to be more stable during the various phases of the business cycle. They are also great places in which to invest when the economic outlook is slowing down, contracting or turning sour.

Property companies, health care companies, and manufacturers of alcoholic beverages and tobacco, are traditionally viewed as part of the defensive companies club given their ability to deliver consistent volumes and cash flow.

Every crisis in financial markets has different winners and losers. Covid-19 turned the traditional defensive plays on their head. Hospital capacity has been one of the most important resources needed during the pandemic. Alcohol is viewed as a risk to the availability of hospital capacity, leading to a second round of sales banning as infection rates soared.

As governments announced lockdown regulations, property companies suddenly had to renegotiate with distressed tenants as footfall, office usage and manufacturing went to near zero, which created risks around the sustainability and defensiveness of their cash flow.

Some of the traditional defensive companies were suddenly in unknown territory. The share prices of some listed property companies are still down about 50% year to date, hospital counters about 30% down, and AB InBev is down just over 20% for the year relative to the overall market, which has recovered to flat for the year to date.  

Covid-19 has introduced new themes to the market. Work-from-home sectors (tech and digital, data service providers) have seen almost no disruption in their activities and are even flourishing in the current environment. Other sectors will face a longer period of recovery (travel and tourism, hotels and entertainment). 

The strength and pace of recovery for different industries and sectors will be dependent on the rate of normalisation of consumer and corporate behaviour and to what extent policy interventions are able to help speed up recovery.

Supply-and-demand dynamics in the resources sector also played out “more defensively” than expected for a sector usually seen as more cyclical. Less geared and safer balance sheets helped the resources companies going into this crisis. The demand disruption for commodities was countered by supply disruptions (less supply due to lockdowns), which meant that a lot of commodities were still in a well-balanced supply-and-demand dynamic, which supported the commodity prices.

As lockdowns started in the East and moved to the West there was also a mismatch between supply and demand created for certain commodities. The exception to this was oil, where the shock to demand was not met by the same slower supply. Geo-political differences at oil cartel Opec caused the June 2020 oil futures contract to trade at a negative value right in the middle of the Covid-19 chaos.  

While we believe social distancing will largely fade over time (as people are social beings), consumer and business activity will have greater online focus. The acceleration in growth we’ve seen in online trading over the last three months is equivalent to growth expected to take five to eight years — it has accelerated the online strategy dramatically.

We also believe companies will focus on reducing leverage, improving liquidity and building resilience by diversifying supply chains (a greater shift to “just in time”, where companies try to minimise inventory costs by producing the goods after the orders have come in, vs “just in case”, in which companies stockpile inventory or support local suppliers).

We believe longer-term structural changes over the coming years are likely to be accelerated by the arrival of Covid-19 such as:

• deglobalisation;
• greater focus on health;
• preference for well-known and trusted brands;
• deteriorating fiscal positions following stimulatory emergency policies, which could pave the way for increases in policies to improve revenues of governments across the world (such as higher taxes);
• a shift in individual and corporate behaviour from leverage to savings, which is a typical reaction to improve resilience after periods of harsh economic conditions; and
• excess capital being used for capital expenditure programmes to diversify supply chains, instead of it being used for share buybacks by corporates globally as it has been in recent years.

In this new world where new rules apply, Ninety One’s preferred exposure in the Ninety One Equity Fund remains with the general miners and platinum group metal miners, which is well balanced with its large exposure to gold and rand-hedge defensive stocks such as Naspers and Prosus.

These stocks’ stable earnings expectations are attractive on a relative basis and have consistently delivered through these volatile markets. In SA, Ninety One’s exposure remains with the banks (predominantly FirstRand and Capitec) and other select counters, such as Sanlam and The Foschini Group.   

Ninety One believes it’s important not to deviate from its disciplined investment process: allocating to stocks with positive earnings revisions at a reasonable valuation. In an environment of broad-based negative earnings revisions, the ability to find corporates receiving overly bearish expectations presents an investment opportunity to take advantage of, as it leads to mispriced valuations.

Visit the Ninety One website for more information.

This article was paid for by Ninety One.