‘Being risk averse in today’s market is not necessarily risk averse’

This article is part of
What Value ‘Defensive’ Investing? - August 2013

Focusing on defensive companies is no longer such a risk-averse strategy in today’s market.

The ongoing effects of anaemic global economic growth continue to play out, with corporations struggling to generate top-line growth and investors scrambling to find yield. Yet one has to wonder if it is time for investors to resume viewing stocks as businesses and not as surrogates for riskless bonds in a slow-growth world.

For the fourth consecutive year, global growth doubts emerged at the end of the first quarter of 2013, with the Russell 2000 index (small-cap index of US stocks) correcting more than 5 per cent from March to mid-April before regaining most of this as the month progressed.

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With growth concerns on the rise again, the ongoing outperformance of defensive ‘bond-proxy’ equities at the expense of more cyclical sectors is no surprise.

After gaining 26.6 per cent in 2012, real estate investment trusts in the Russell 2000 were up another 18.8 per cent in the first four months of the year, while utilities advanced 14.8 per cent.

But being risk averse in today’s market is not necessarily risk averse: chasing yield in defensive sectors and searching for risk-free returns carries increased valuation risk and is one of the by-products of the no-growth world in which we live.

The paradox of such an environment is that it should focus investors on better businesses with the financial and operating strength to thrive in an uncertain world. That said, the idea rates will remain low indefinitely has permeated the investment landscape at the precise moment the credit re-rating of riskier corporations is behind us.

Excess free cashflow gives companies the flexibility to focus on effective capital allocation. Free cashflow generation is linked to a stock’s ability to sustain positive revenue growth and produce high internal rates of return.

With the flexibility of excess free cashflow, companies can focus on effective capital allocation, which includes capital expenditures, buybacks, debt repayment, and even dividends. This is of paramount importance in today’s low-growth environment as corporations struggle to generate top-line growth.

Prudent capital allocation should be the catalyst to a powerful investment cycle once the fog of anaemic economic growth and near-zero interest rates lifts.

Frank Gannon is portfolio manager and principal Royce & Associates