There has recently been a steady stream of financial articles declaring that the main driver of the excess performance of traditionally ‘defensive’ sectors such as consumer staples and utilities is solely attributable to the decline of interest rates to near-record lows. For example, in Monday’s Wall Street Journal, columnist Justin Lahart wrote:
Then, on Tuesday, Mr. Lahart’s colleague at the Journal, Mike Bird, added:
Now, it is beyond dispute that multiples [as gauged by the trailing twelve-month (or TTM) price-to-earnings ratio] are stretched in many of these defensive sectors. For example, the TTM P/E on the SPDR Consumer Staples ETF, XLP, is at the highest level since data became available in late 2005:
The same is also true for XLP’s Utilities counterpart, XLU:
This is in stark contrast to what are considered “high beta” sectors, such as technology (XLK), the multiples of which are below recent peak values:
and financials (XLF):
However, looking at sector multiples in isolation, I believe, can be misleading. A superior way to examine multiples and the potential cause(s) of their expansion or contraction is to look at them relative to the overall market. This gives an investor proper context for what is going on in the market overall. This helps to avoid, in my opinion, the tendency to see two things in isolation, and conclude that one result was the direct consequence of something else. [Note: Without doubt, there are superior gauges of valuation to TTM P/E such as CAPE or Forward P/E, but, unfortunately, those data were not available.]
To that end, I grouped the traditionally defensive sectors (healthcare, utilities, and consumer staples) together into a “low volatility” category, while grouping together the “high beta” sectors, such as energy, financials, and technology. By subtracting the trailing twelve month P/E multiple from each sector, we can see where excess valuation stands now compared to prior periods.
Here are the results for the “low volatility” sectors:
In each case, the excess valuation for the “low volatility” sectors is back to the top of the range, but not necessarily far beyond where they were at the prior peak. Furthermore, when adding the additional variable of the 10-year Treasury yield, we can conclude that while falling yields have most likely been a factor in the performance of these traditionally high-dividend paying sectors, it would be a mistake to ascribe all of the outperformance to yield-chasing as excess valuation is back to where it was years ago when yields were much higher:
By comparison, a main driver of the “high beta” group, technology, has seen its multiples in a secular decline really since the tech bubble burst in 2000, while financials and energy have generally traded at a discount to the overall market for much of the period observed:
Perhaps a better explanation for the divergence in valuations between the “defensive” and “high beta” sectors may be that investors, after being burned by two recent bubbles in two of the higher-beta sectors, have learned a hard lesson after overpaying for tech stocks circa 2000 or by chasing banks prior to the financial crisis of 2008. After all, as we discussed in a recent post, by owning sectors such healthcare, utilities, and consumer staples, investors may not have enjoyed all of the returns of the overall market, but they’ve not been subject to nearly the downside risk as owners of the higher-beta sectors:
Another consideration may be that sectors that feature companies with certain characteristics warrant a premium valuation to their peers. Using Portfolio Visualizer‘s wonderful regression analysis tool, we can compare and contrast the featured sectors side-by-side:
It becomes obvious that the “low volatility” sectors do not give as much market exposure as their high-beta counterparts, but they do give reasonable exposure to value, while scoring high in the quality and low beta factors. Over the time frame studied (August 2005 – July 2016), they generated more alpha (or risk-adjusted return) than their high-beta peers.
In sum, while low rates have most likely contributed to both the performance and the multiple expansion of the “low volatility” sectors, it is clear that other forces are in play as well. In many ways, two of the major high-beta sectors are still working off the froth of recent bubbles in their valuations, and energy (the highest single weighting in the S&P High Beta index) is languishing in the aftermath of a period of extreme over-investment.
That brings us back to a theme we addressed in April, namely that investors have, historically, overpaid for innovation, and they have discounted stability. In his column referenced above, Mr. Bird asserts (regarding consumer products maker, Unilever), “[S]ince it makes its money in everyday consumer items, rather than some potentially revolutionary new technology, it does suggest that it is extremely highly valued.” But this is to assume that ‘innovative’ companies warrant a premium multiple. In fact, historically, innovative companies have been a disappointment to investors, while boring old consumer staples have been a top performer, while being discounted. As Patrick O’Shaughnessy wrote in 2014:
While their valuations are currently high relative to their histories, perhaps the fact that their returns have been more consistent and their valuations less prone to excess are additional reasons why investors are willing to pay up for them today.
Note: In the Patrick O’Shaughnessy post referenced above, he notes in the original post that the “cheapness” of consumer staples was measured by a composite of “p/sales, p/earnings, ebitda/ev, etc.”
Disclosure: Past performance is no guarantee of future results. Both the author and clients of Fortune Financial hold positions in some of the securities mentioned.
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