EDINBURGH, SCOTLAND - MARCH 19: Members of the public examine whisky samples inside the Diageo Claive Vidiz Collection, the world's largest collection of Scottish Whisky on display at The Scotch Whisky Experience on March 19, 2014 in Edinburgh, Scotland. Chancellor of the Exchequer, George Osborne announced today in his final budget before the Scottish independence referendum, that duty on Scotch whisky is to be frozen. (Photo by Jeff J Mitchell/Getty Images)
Handle with care: defensive stocks, such as whisky maker Diageo, appear expensive © Getty
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Surrounded by idiots? One and a half million people suspect they might be — judging by sales of a book of that title by Swedish behavioural analyst Thomas Erikson. But a growing number of portfolio managers now seem certain they are — judging by some of the purchases that have been booked by their fellow investors.

“Bond prices are idiotic,” complained one exasperated hedge fund watcher to the Financial Times a few weeks ago. “They’ve reached stupid levels”.

“Defensive dividend-paying equities are without doubt expensive by comparison to any ‘sensible’ historical context”, sighed a chief investment officer, “the problem is . . . they are still cheap by comparison to the lunacy of government bonds.” Another wealth manager worried that fools might be rushing in to all the same high-yield shares: “There are lots of defensive strategies available that are more thoughtfully constructed.”

To some, the apparent idiocy of some equity valuations reflects an almost comical bond market. Tom Becket, chief investment officer of investment manager Psigma, blames central bankers who “made the concept of ‘sense’ extinct”. He cites Nestlé, the Swiss food group deemed a defensive holding for its steady dividends. Investors seeking income, or real-terms wealth preservation, have bid up its market value to nearly 30 times last year’s earnings, reducing its dividend yield to 2.3 per cent. But as Becket points out: “10-year Swiss government bonds trade with a tragicomic yield of minus 0.64 per cent. Could Nestlé trade on 50 times earnings and yield 1.15 per cent and still be considered good value when compared to local government bonds? Why not?”

He is not alone in seeing a “redundancy of historical valuation practices”. Stéphane Monier, CIO at Swiss bank Lombard Odier, also identifies “pockets of excessive valuation in some defensive sectors, particularly in utilities”.

And for wealth managers like them, that brings an irony — and a problem. As Alexandre Tavazzi, strategist at Pictet Wealth Management, points out, when supposedly safer shares become ever more sought after by an unwise crowd, there is a danger that prices will reverse. “The valuation spreads of minimum volatility indices over value [indices] in the US and Europe currently stand at 40 and 56 per cent, respectively — these spreads are at their highest level over the past 10 years,” he warns. “Being too defensive can also be risky.”

It is for this reason that Katie Nixon, CIO at Northern Trust Wealth Management, says “the portfolio manager must be cognisant of the unintended risks potentially taken in defensive dividend yielding strategies”. But is it a reason for wealth managers to sell defensive stocks now, or think differently about them? Given so many clients still need income, or at least a hedge against inflation, many suggest the latter approach.

“The key is to make sure valuation is considered within the context that we are in — and not versus a historical context that may not be true any more,” advises Chris Gannatti, head of research for Europe at US asset manager WisdomTree. “In a world of super-low interest rates and further quantitative easing from central banks, the valuations of these stocks should be higher.” Like Becket at Psigma, he thinks the way in which investors value dividend-paying stocks when government bond yields are negative should be different to when yields were 2-3 per cent. Unlike Becket he thinks this is more reality than lunacy.

Joseph Little, chief strategist at HSBC Global Asset Management, has come to a similar conclusion: “We might need to revisit our definition of what truly defensive equities look like”.

For those still struggling to redefine these assets, Mouhammed Choukeir, CIO at Kleinwort Hambros, suggests an alternative way of looking at them. Drinks company Diageo — “a classic defensive stock” — has a historic average price/earnings ratio of 18 times, and so looks classically overvalued now that it is trading on 26 times. But its earnings yield — the inverse of the P/E ratio — is 3.8 per cent which, while less attractive than its 20-year average of 5.8 per cent, still indicates better value than those 10-year bond yields.

Then, the question becomes achieving diversity rather than avoiding duncery. Yogi Dewan, chief executive of Hassium Asset Management, stresses a geographical spread. “In the US we would have a neutral stance . . . In Europe fundamentals are not as convincing, but valuations are fair.” Others advise a combination of sectors, or valuation characteristics.

Might cyclical, or more volatile, shares even be worth holding again? Little says “we do think it is time to lean into the contrarian trade and have a bit more value and cyclical exposure in portfolios”. For exasperated wealth managers, this offers another benefit: by definition, you can’t be surrounded by contrarians.

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