Wednesday, April 15, 2009

Defensive Stocks?

Companies like Johnson & Johnson (JNJ) and Procter & Gamble (PG) are usually referred to as "defensive stocks". Well, as it turns out, that's not really been the case based upon returns over the past 20 years. The word "defensive" implies more modest overall returns as a trade-off for more downside protection.

In fact, those two stocks -- and others with similarly durable economic characteristics -- historically have had higher long-term overall returns combined with their defensive characteristics.

Stock                                         |20-Year Return
Johnson & Johnson (JNJ)|   784%
Procter & Gamble (PG)        |   713%
Coca-Cola (KO)                     |   580%
Pepsi (PEP)                             |   561%
Hershey (HSY)                      |   408%

S&P 500                                   |  179%
Source: Yahoo! Finance

The returns posted above include only the capital gains portion of the 20-year return. Include the dividends and the total return, of course, is actually much higher. As a result, the above understates the performance gap since the dividends these companies pay are typically bigger than an index fund based upon the S&P 500. The bottom line: many of these companies have historically outperformed over the long run at lower risk, at least in part, for the simple reason that they have been higher quality businesses.

At least that is my view.

Durable high returns on capital ends up mattering a whole lot in investing.

Generally, these businesses tend to have it. My preference, these days, happens to be Philip Morris International (PM) and Diageo (DEO), but certainly others could be attractive if bought at the right price.* 
(PM was a spin-off from Altria (MO) in 2008. DEO was formed in 1997 through a merger between Guinness and Grand Metropolitan. Neither PM or DEO has 20 years of U.S. trading history as separate marketable stocks so their results have not been included above. Guinness and Grand Metropolitan did trade publicly before the merger.)

Altria also did extremely well -- including, of course, the value of the recent spin-offs -- over the past 20 years. In fact, Altria's stock performed better than all the other stocks above (well, at least those with a long enough trading history). Over the long haul, few stocks can match Altria in terms of historic total returns. Starting in early 1957 -- when the S&P 500 was launched -- through 2006, Altria's stock produced a 19.88% annual return (incl. reinvested dividends). 

So a $ 10,000 investment would have increased to over $ 80 million during that time. In comparison, $ 10,000 in the S&P 500 would have increased to $ 1.68 million.

There is, of course, nothing wrong with those S&P 500 results. For some perspective, keep in mind that investment professionals -- those who actively engage in stock picking in an attempt to perform better than a broad-based index -- tend to have a tough time matching the S&P 500.

I've included Hershey (HSY) above but, unlike the others, it is just not a stock I follow closely enough (for ownership to be a consideration).

I also don't happen to closely follow something like General Mills (GIS) though it's certainly another relevant example. The company's shares have similarly done just fine compared to the S&P 500 over the past 20 years. I just happen to be a bit less comfortable with that particular business.

The list doesn't end there. My point being, though there are always exceptions, it is difficult to find shares of businesses that produce leading small-ticket consumer branded products (fast-moving consumer goods: FMCG), with sufficient distribution and scale, that did not produce at least solid total returns over those 20 years. The best of these generally have a combination of the strongest brands, outstanding distribution, and scale. This doesn't mean their future prospects remain as attractive as they have been in the past. In fact, I'd be surprised if that's the case. Nor does it imply that these businesses and their shares are equally attractive. They surely are not. Some seem more likely than others to be able to at least maintain a healthy economic moat. Some appear to have superior core economics. Those that do, if bought at reasonable or better prices, should at least improve the chances for attractive long-term investment outcomes.

Each necessarily has unique advantages, challenges, and prospects that need to be well understood. It just never makes sense to invest in an asset that's not understandable. (What can be "well understood" is necessarily unique for each investor, of course.) This, to me, is a sensible principle no matter how compelling future prospects appear to be.

Ignoring "the noise" (and there's usually lots of it) depends on strong and warranted levels of conviction. Investing in what's understandable and likely to have a narrower range of outcomes is not a bad place to start when it comes to this.

Now, the reality is that prior performance should provide motivation for further analysis but that's about it. In other words, the fact something has done well in the past shouldn't, in itself, be all that interesting. The competitive landscape inevitably changes over time potentially damaging -- at least to a degree -- what were once attractive business economics. This is true even for very good businesses.

Still, check out the long-term investment results over different time horizons (i.e. something like several different 20 year time horizons other than the past 20 years) for these and other similar high quality businesses. Also, check out much longer time horizons. I think any objective look at this will more than suggest that many -- even if not all -- shares of the higher quality businesses historically produced rather solid or better long-term risk-adjusted results.
(Over the shorter run anything can happen as far as relative and absolute performance goes. I'd argue that at least a full business cycle or two is needed to judge performance.)

Well, especially if bought at a nice discount to intrinsic value but, at the very least, at a reasonable valuation. What's a smart buy at a plain discount to value isn't at some higher premium price no matter how good the business may be.

Also, as with any business, whether management is capable of sustaining and even increasing the moat matters a whole lot. As does competent capital allocation and a sound balance sheet.

These are elements of intrinsic value that are hard to measure yet still very real.

Of course, what ultimately matters is how these businesses and their shares perform going forward. Getting that at least mostly right still requires plenty of work.

In other words, just because something that seems to be a higher quality investment -- and has done well in the past -- guarantees nothing.

"If past history was all there was to the game, the richest people would be librarians." - Warren Buffett

The question is whether the best of these continue to possess durable advantages.

At a minimum, the above at least suggests that those who knew how to judge business value could have: 1) taken "inventory" of leading small-ticket consumer brands in use everyday, 2) bought the corresponding stocks at a fair price (or, better yet, when they were occasionally selling at a plain discount to value), 3) held them long-term, and 4) achieved more than satisfactory risk-adjusted results. This is a simplification, of course, but a deliberate one to emphasize that sound investments are sometimes in plain view.

Minimal trading and frictional costs.

Complex strategies not always required.

This all promises nothing about the future but does seem, at least, not a bad place to start.

The best of these franchises continue to have attractive risk and reward characteristics if bought at the right price. Still, it seems unwise to expect nearly as attractive returns going forward.
(Now, if performance turns out to be better than expected, there'll be no complaints.)

In contrast, the average actively managed mutual fund underperforms the S&P 500. According to Vanguard founder John Bogle, from 1984 to 2002 mutual funds on average delivered a 9.3% annual return compared to the S&P 500's return of 12.2% a year.**

"The reason for that lag is not very complicated: As the trained, experienced investment professionals employed by the industry's managers compete with one another to pick the best stocks, their results average out. Thus, the average mutual fund should earn the market's return—before costs. Since all-in fund costs can be estimated at something like 3% per year, the annual lag of 2.9% in after-cost return seems simply to confirm that eminently reasonable hypothesis." - John Bogle

Some commentators seem to suggest it's possible to jump in and out the shares of a high quality business based upon whether a defensive posture is warranted or not.

Well, correctly doing this without making mistakes (and creating unnecessary frictional costs) seems like a good idea mostly in theory, less so in practice. In fact, there's plenty to suggest this might be less than a brilliant approach. It's not just that the average mutual fund underperforms. It's worse than that.

Here's what Jack Meyer, who managed the endowment, pension, and other assets as President and CEO of the Harvard Management Company from 1990 to 2005, had to say:

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value." - Jack Meyer

Of course, there are more than a few exceptional professional money managers with proven track records but, in the real world, it's just not easy to identify who'll outperform beforehand.

Investors add complexity and risk to the investing process that often isn't necessary.

For many reasons, shares of these and similar higher quality businesses seem unlikely to perform nearly as well on an absolute basis in the future.

Maybe that's a conservative view. Maybe not.

In addition, judging value well and buying them at a plain discount to intrinsic value (i.e. with a margin of safety) still, as always, matters a bunch. Again, what's sensible at a plain discount to intrinsic value doesn't make sense at some materially higher valuation. Also, a stock that persistently sells at a discount to per share intrinsic value allows buybacks and reinvested dividends to be more effective. This can improve -- all else equal -- long-term results. A high market price relative to value is only beneficial when it comes time to sell. Naturally, this also means that a stock that frequently sells at a full (or a premium) valuation reduces long-term results. So if some of these stocks were to get fully valued and stay fully valued returns will actually be worse over the longer haul. Something to consider the next time a stock owned for the long-term heads higher in the near-term.

A near-term rally may be good for the trader (with a long position) but certainly is not for continuing shareholders who've invested with decades in mind.

In any case, the relative risk-adjusted merits for the best of these consumer businesses seems likely to remain not insignificant if the shares are bought reasonably well in the first place. They can offer a simple (if not necessarily easy) yet effective means of producing results.

It's worth mentioning that Warren Buffett's long-term results didn't necessarily come from trying to outperform during bull markets. He once wrote:

"Our performance, relatively, is likely to be better in a bear market than in a bull market..."


"In a year when the general market had a substantial advance, I would be well satisfied to match the advance of the averages."

The point is certainly not that consumer defensive stocks are capable of matching Buffett's long-term performance.

Not at all.

The point is that judgments about performance shouldn't be solely based upon what happens during a bull market; it's that outperformance during bull markets isn't necessarily required to get good overall long-term results. The focus should be on the combined result across all market environments over many years and, better yet, multiple decades. In fact, these so-called defensive stocks will likely live up to their reputation during bull markets and bear markets. That means they are not likely to quite keep up during a steadily rising market. If they did it'd likely be resulting from market price action outpacing increases to per share intrinsic value. Not sustainable. It's in bear markets and difficult economic environments that that they will usually demonstrate their strengths. This bull and bear market dynamic tempts some market participants to try and only own the more defensive stocks at the right time. Well, that seems like a better idea on paper than it is in reality. Mistakes and frictional costs make that rather tough to reliably do well.

I'm guessing this won't stop some from trying to pull it off.

A few might even do this effectively but, at the very least, some skepticism is warranted.

When it comes to consumer defensive stocks, it's attractive core economics and the persistence of their earning power -- on a compounded basis over long time horizons -- that's the key. Well, it is as long as excess capital is generally put to good use and the price paid is at least reasonable.

The importance of performing relatively well during bear markets is sometimes underappreciated. While there's no way to know how well the better among these consumer defensive stocks will do in the future -- in the context of risk, reward, and possible alternatives -- they're not the worst place to begin looking for long-term investments.


* Long positions in PG, JNJ, KO, PEP, MO, PM, and DEO. These are stocks I consider attractive long-term investments if bought at the right price for my own portfolio. In other words, I never will have an opinion as to what others should or should not be buying or selling. My judgment may also turn out to be very wrong, of course. Going forward, I happen to think that both PM and DEO have very attractive business economics and durable advantages that are at least as good as most "defensive stocks" (and likely better than some of the others listed above). I don't think the reputation for these being defensive stocks is incorrect, it's just incomplete. Yes, defensive stocks usually have less than exciting price action and volatility and are likely to do better in bear markets. Yes, they're also likely to not do particularly well in bull markets. Anyone buying these stocks expecting them to outperform during the next bull market is likely to be disappointed. That is, in part, how they have earned the reputation of being defensive. Yet, this defensive reputation isn't quite correct when you look at their historic returns over the longer haul. So it's when they're looked at over longer time frames (more than a full business cycle or two) that the picture becomes more clear. Long-term offense and defense. Higher quality businesses. Of course, like any investment, they've still got to be purchased with a margin of safety. Many of these seem not particularly expensive at all in April 2009, but who knows if that persists. As with any business, a healthy balance sheet still matters but, generally speaking, the best of these tend to have more than respectable financial strength. Capable management and wise capital allocation naturally also matters. Now, even if shares of the higher quality businesses didn't match long-term market performance going forward (and they may not, of course), the sheer simplicity of the approach compared to alternatives needs to be considered. So does the reduced likelihood of permanent capital loss and more narrow range of outcomes. In fact, if the quality franchises produced merely market returns over the longer haul, they'd still win in my book. The reason is that, if bought well, the same return will have been arguably achieved at less risk of permanent capital loss (not temporary paper losses).
** This study was limited to mutual funds. Some might wonder how hedge funds have performed long-term. Here's a paper by Burton Malkiel and Atanu Saha that provides some insights on hedge fund risk and returns.
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