Last week gave investors a sneak peek into the type of tail event that can happen when central banks tighten to the extremes we have seen over the past 12 months.
Silicon Valley Bank (SVB) looks reasonably contained in terms of geography (US) and in terms of niche (venture capital/tech), but shows how quickly market sentiment can change.
We are not changing the portfolio due to the collapse of SVB, but the event highlights how important defensives are in a portfolio, especially in such uncertain times.
As we continue through this slowdown period, investors will have to navigate a period where economic and earnings growth could be vulnerable to downward revisions.
Over the past 12 months we have increased our weighting to defensives that we believe will be more resilient to increasing downside risk from a slowdown in the global and domestic economy.
On our mapping, defensives represent ~25% of the ASX 300, and the Wilsons Australian Equity Focus Portfolio is currently sitting around that balance at 24%.
The way we differentiate ourselves from the market on our defensives allocation is through the type of defensives we favour. Our preference is towards growth defensives (healthcare, consumer services) rather than low growth defensives (consumer staples, utilities).
Why Do We Prefer Growth Defensives?
Higher returns
The Focus Portfolio holds a selection of high-quality, high-margin, defensive businesses with strong competitive advantages, pricing power, and relatively attractive long-term growth prospects.
We believe these companies are likely to grow their earnings faster than the market over the medium term, which should translate to outperformance over time.
Using the healthcare sector as a proxy for growth defensives, we can see the sector has outperformed the consumer staples sector (which contained Wesfarmers (WES) until 2019) and the broader market over a 10 year period. However, the sector has struggled during the COVID period, which we think is set to change.
Case Study: CSL (CSL) vs Woolworths (WOW)
We take CSL vs WOW as an interesting case study to demonstrate how important growth is for investing. In 2013, CSL would have looked “expensive” relative to WOW, with a 12mth fwd PE of 21x vs 13x. If we invested $100k into CSL and WOW in 2013, by today, the 2013 ($100k) investment in CSL would be $525k or an 18% annual capital return (driven by earnings growth), while WOW would be at $142k or a 3.6% annual return (including dividends WOW would have generated a 5.4% annual total return).
The growth outlook for CSL still looks impressive, with an expected 24% EPS CAGR (FY23-FY25). WOW has an EPS CAGR of 7% on a PE of ~25x, which we struggle to justify based on this growth.
| Start 2013 | CSL | WOW |
| Investment ($) | 100,000 | 100,000 |
| Price ($) | 53.9 | 25.901323 |
| EPS (12 mth fwd) ($) | 2.6 | 1.9 |
| Price-to-Earnings (x) | 20.99 | 13.31 |
| DPS (12 mth fwd) ($) | 1.00 | 1.38 |
| Spot forward dividend yield | 1.9% | 5.3% |
| Current (14/3/2023) | CSL | WOW |
| Investment | 525,473 | 142,078 |
| Price | 283.23 | 36.8 |
| EPS (12 mth fwd) | 9.6 | 1.5 |
| Price-to-Earnings | 29.4 | 24.9 |
| DPS (12 mth fwd) | 4.05 | 1.09 |
| Spot forward dividend yield | 1.4% | 3.0% |
Source: Refinitiv, Wilsons.
Delivering downside protection
We think growth defensives like CSL are valued more attractively (relative to their growth outlook) than the low- growth defensives. Still, like ultra-defensives, these companies should also demonstrate relatively resilient earnings through the economic cycle, providing protection against a slowdown, recession or tail risk event.
This is reflected in their low market betas as these stocks are typically less volatile than the market.
Valuations reasonable in the light of growth profile and quality of earnings
While these stocks offer higher growth, they come at higher valuations relative to the market. These stocks should have a low correlation to the broader economy. So, while valuations look 'expensive' on a standalone basis, we think they are reasonable considering the global slowdown, quality of these earnings (acyclical and resilient) and their strong growth profiles.
Bond yields: headwind to tailwind
Valuations for growth defensives have come under pressure from rising bond yields. Stocks which are generally considered to be growth-oriented could benefit if inflation fades, central banks pivot and bond yields compress. Therefore, we want to be positioned towards these growth defensives that should benefit if bond yields continue to fall.
Foundations of a Strong Portfolio
CSL (CSL), ResMed (RMD), IAG (IAG) and Cleanaway (CWY) all provide the focus portfolio with defensive capabilities.
They also all fit the mould of growth defensives, with strong growth profiles to match their higher-than-market-valuations while delivering lower volatility than the market.
Lotteries (TLC) a Winner
Our top defensive pick is The Lottery Corp (TLC) (Focus Portfolio 3%), which has predictable, infrastructure-like cash flows that are underpinned by its long-dated licences and the defensive nature of lottery demand which has historically been resilient through the cycle.
TLC may look expensive relative to its growth profile, however, we believe the consensus earnings are too pessimistic. The increasing penetration of digital channels should lead to higher margins than consensus. For example, the 1H23 EBITDA margin of 21.3% is higher than the FY25E margin of 21.1%, which we think is too conservative. TLC's monopoly on lotteries in Australia further contributes to the higher multiple.
Defensive Opportunities
We have two other opportunities that may be of interest to investors with a more defensive risk profile.
Ramsay Health Care (RHC)
Wilsons Research: Overweight rated
Ramsay Health Care is a private hospital operator in Australia, Asia, the United Kingdom and France. It operates large metropolitan facilities, veterans’ hospitals, rural centres, psychiatric units and day surgery/clinics. Domestically, Ramsay is engaged in a program of brownfields expansion, looking to add capacity to service an ageing population. Abroad, Ramsay looks to acquire hospital groups and implement its own operating style and margin discipline.
Recovery in elective surgery after COVID
We view RHC as a ‘quality defensive’. Notwithstanding the unprecedented impacts of COVID-19 lockdowns, the underlying patient demand for private hospitals is typically resilient through the economic cycle given non-elective care is an essential household expenditure item, while even elective procedures are considered relatively non-discretionary compared to most other household expenses. We believe RHC will continue to see patient volumes recover in a post-COVID world.
Wilsons healthcare analysts’ forecast an EPS CAGR of 36% (vs consensus of 26%) between FY23E and FY25E, driven by a recovery in surgeries, strong underlying utilisation trends, raised prices for payers, dwindling COVID costs, and continued brownfield activity.
Valuation supported by growth/defence and underlying assets
RHC trades on a 12-month forward PE multiple of 29.2x, which we think is very attractive relative to the strong EPS growth expected over the medium-term. This is based on Wilsons’ 3-year EPS CAGR, RHC trades on a compelling PEG (PE / EPS CAGR) ratio of just 0.7x (vs the ASX 200 at ~1.5x).
RHC’s portfolio of owned real estate assets – which have a book value of around $5bn as of 31 December 2022 – add to the defensiveness of the business and serves as a valuation floor.
Treasury Wine Estates (TWE)
Treasury Wine Estates is a vertically integrated producer, marketer and distributor of premium-focused wine, which operates in more than 70 countries globally.
Wine demand is resilient over the cycle
TWE has both structural growth and quality defensive characteristics. On the structural growth side of the equation, the business is poised to deliver meaningful earnings growth as it executes its premiumisation strategy which is poised to drive material margin expansion over the medium-term. On the quality defensive side of the equation, wine consumption is typically relatively resilient through economic cycles.
Bottled-up demand from China becoming a tailwind
Prior to COVID, Chinese tourists were TWE's top market for high-margin duty-free and cellar door products (especially those from Penfolds). There may be a material earnings upside from the rapid reopening of China's economy and a surge of Chinese tourists coming to Australia.
Uncorking China-Australia relations
TWE is leveraged to China’s re-opening. In recent years, the business has been heavily impacted by souring Sino-Australian relations when China placed tariffs of more than 200% on Australian wine exports in late 2020. Prior to then, TWE was the #1 wine importer in China and >40% of its EBIT came from Asia (predominantly China). TWE was relatively successful in re-allocating its products to other fast-growing markets which helped soften the hit to earnings.
Nonetheless, improving bi-lateral relations between Australia and China could see the market re-open for business for TWE. Recent dialogue suggests China may be willing to reduce or completely remove the tariffs on Australian wine with government officials stating they are ‘willing to communicate on some technical issues in bilateral trade which are of concern to both sides’.
Therefore, a more constructive backdrop for bilateral trade, coupled with the loosening of China’s COVID restrictions earlier this year, could drive a meaningful earnings upgrade for TWE which is not yet priced by the market.
Growth and defensive characteristics justify valuation
From a valuation perspective, TWE trades at a 12-month forward PE multiple of 22.4x, which offers compelling value considering its 3-year consensus EPS CAGR of 15% where we see material upside if China loosens its restrictions on wine imports.
Written by
Rob Crookston, Equity Strategist
Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.
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