Thursday, March 3, 2011

Defensive Stocks Revisited

Yesterday, on CNBC's Strategy Session, Gary Kaminsky discussed the results of a new study by Interactive Data. The study showed less volatile stocks (lower beta) outperform the S&P in the longer run.

...a new study by Interactive Data shows that (contrary to popular opinion) low beta stocks outperform the S&P's annualized 8.8% return over long time horizons.

These results are quite at odds with the prevailing wisdom (a loose use the term if there ever was one). The following stocks are supposed to be more defensive in nature yet they've proven to be a whole lot more than that over the long haul.

McDonalds [MCD]:
Beta = 0.63
20-Yr Annualized Returns = 13.7%

Colgate Palmolive [CL]:
Beta = 0.60
20-Yr Annualized Returns = 13.5%

Church & Dwight [CHD]:
Beta = 0.46
20-Yr Annualized Returns = 13.4%

It's a new study but a subject I've covered in a number of (maybe too many?) previous posts.

Also, check out how some of the higher quality -- and, yes, sometimes rather boring -- stocks performed over even longer time horizons.

Owning shares of businesses with characteristics similar to the above is often both good offense and defense even if their reputation is that they're more the latter. This simple insight is, and has been, central to my approach to investing in equities for quite some time.*

Typically, these entities share the following characteristics:
1) predictable revenue and earnings growth
2) durable high return on capital
3) sustainable competitive advantages (often derived by strong brands, wide distribution etc.)
4) pricing power

It's also rather important that they more than occasionally have capable management with above average talents when it comes to allocating capital.
(But investors have to expect that won't always be the case. So it's better to own businesses that can withstand the occasional unwise move by management yet still deliver attractive returns for the owners.)

Consumer staple stocks seem unlikely to perform nearly as well on an absolute basis in the future. Being capable of judging value well -- like any investment -- still matters. Buying them at a plain discount to that estimated intrinsic value (i.e. buying with a margin of safety) still matters. Yet, the best among them have relative risk-adjusted merits compared to alternatives that remain not insignificant over the long haul.
(Over the shorter run -- less than five years or so -- anything can happen as far as relative performance goes, of course.)

Here's some previous blog posts that cover high quality stocks and why a title like "boring" or "defensive" is not, at a minimum, an adequate description:

KO and JNJ: Defensive Stocks? - January 2011
Altria Outperforms...Again - October 2010
Grantham on Quality Stocks Revisited - July 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - November 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - April 2009
Best and Worst Performing DJIA Stock - April 2009
Defensive Stocks? - April 2009

These posts explain, in part, why I like owning shares of the great franchises as long-term investments. Yet, I will still only buy if they're selling at a plain discount to my estimate intrinsic business value.**

What's sensible to buy at a plain discount to intrinsic value doesn't make sense at some materially higher valuation.

The ride may not be exciting (and returns likely will not look so great on a relative basis in a rapidly rising market environment) but the probability is not low for attractive investing results at lower risk over something like a 20-year horizon.

As I've said, even if shares of the higher quality businesses did not outperform over the long haul 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.

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

In other words, just because something has done well in the past guarantees nothing, though it does seem, at least, not a bad place to start.

The companies with leading consumer brands, strong distribution, tend to experience little change. They sell nearly the same products year after year; they maintain their competitive advantages; they also tend to be built to last. Combine this with attractive and durable core economics, and the compounded effects, in the long run, are not small. Innovation is critical for the world but picking the winners is usually not easy. For each winner there are many losers, and avoiding the losses associated with those losers is tough to do consistently. Also, those with exciting prospects tend to have market valuations that assume just about everything will go right.

Well, if things do go wrong -- and the price that's paid should always assume things will -- the end result is permanent capital loss or, at least, an undesirable result in terms of risk and reward.

Picking the winners among the leading companies with durable advantages, high returns on capital, that are otherwise mostly rather boring is, by comparison, a whole lot less challenging.

* Extremely active traders interested in quick gains will surely find this to be of little interest. I mean, the approach may lack excitement but that seems hardly relevant. This is primarily about owning part of an understandable, high quality, business franchise with results coming primarily from increases to per share intrinsic business value over a long horizon, not exceptional trading abilities. Besides, I happen to find businesses like Coca-Cola (KO), Pepsi (PEP), Diageo (DEO), and Philip Morris (PM) very interesting even if their stock price action tends toward the unexciting. These businesses tend to just quietly compound in value. Those with the very best brands, scale, and distribution capabilities tend to have durable advantages that are often not at all small. It is the durability of their advantages that increases the likelihood they'll continue creating real value over a long horizon. Many common stock alternatives, those shares of businesses with more questionable competitive advantages, offer no where near the same kind of visibility. As a result what seems cheap now is anything but cheap. Durability matters. It's not that the share prices of higher quality businesses -- for a variety of reasons both macro and micro in nature -- can't drop dramatically from time to time. You bet they certainly can and do over the near-term or even longer. Yet, if it's a sound business that's increasing per share intrinsic value, the stock price action will eventually move in accordance with that reality over the longer haul. 
** No one should buy what they don't understand. No one should buy what they don't know how to value. If you bought these stocks at late 1990s valuations, returns relative to the S&P would still be impressive. Yet adequate risk-adjusted absolute results cannot usually be achieved if you pay the kind of earnings multiples that prevailed for some consumer stocks back then. In other words, it wasn't just the tech stocks that were overvalued.
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