TMO - Time To Go Defensive With These ETFs

2023-08-02 04:05:54 ET

Summary

• High-beta stocks have outperformed defensive stocks in the stock market recently, raising questions about the effectiveness of low-volatility and dividend growth investing.
• ROBECO's research shows that low-volatility investing can significantly improve long-term performance, particularly in market environments with increased retail investor participation.
• Low-risk ETFs, such as healthcare names and dividend aristocrats, offer exposure to fundamentally strong factors and tend to perform well during periods of stagflation, high inflation, and decent economic growth.

Opening Remarks

The stock market has been on a tear lately, with the most volatile stocks crushing their defensive counterparts. Just look at the return difference between the high-beta ( SPHB ) and minimum-volatility ( USMV ) stocks. The same can be said for the healthcare ETF ( XLV ) and the US Dividend Aristocrats ( NOBL ), albeit to a lesser extent for the latter.

Now, it's quite remarkable to witness such underperformance in 2023. Admittedly, defensive stocks held up much better during the 2022 meltdown, but their upside capture in today's market environment has been nothing but disappointing. This, in turn, makes many believe low-volatility and dividend growth investing is dead.

Even more surprising when considering one of the most powerful market paradoxes: the concave return-risk profile. More risk-taking does not correspond with a linear return relationship, measured on a rolling long-term basis and based on a wide basket of stocks. In other words, you could end up feeling lucky with a few high-beta stocks, but a whole collection of risky assets will demolish your risk-adjusted performance. The steadier your return trajectory, the easier your investment career is going to be.

The following graph depicts ROBECO's ground-breaking research findings around this topic. In market environments where retail investor participation is on the rise, the effect of low-volatility investing on your long-term performance will improve drastically (both in absolute and relative terms).

While buying lottery tickets on the stock market might be tempting for some period of time, low-risk stocks provide the highest risk-adjusted return with an absolute return at least equal to that of the broader index.

Is it time to turn bullish on these conservative investment themes? Let's find out!

Low-Risk ETFs Have Exposure To Fundamentally Strong Factors

For investors, including myself, who make periodical contributions to their investment portfolio, an even stronger case can be made for low-risk ETFs. Think of your healthcare names, dividend aristocrats, consumer staples that show resilience regardless of the economic environment.

In most cases, valuation multiples of low-risk stocks have shrunk because of earnings growth, relatively stagnant price action and lack of exposure to fancy technology trends.

As per ROBECO, conservative stocks should provide alpha during periods of stagflation, high inflation and decent economic growth. Moreover, on the valuation front, defensive stocks tend to outperform by losing less in the down markets, especially when the earnings yield and thus risk premium is low.

The above mentioned sector ETFs embrace several styles like dividend growth, quality, low-vol, long-term momentum et cetera. It's very difficult to time styles or factors, highlighting the process of dollar-cost averaging each and every month or quarter will smooth the risk of bad timing out.

One cannot predict what will happen next in terms of relative performance, but based on statistical data and long-term evidence, coupled with a sound fundamental rationale, low-risk stocks make investing easier. Of course, it depends on your personal goals and time efforts. Traders won't pick low-risk stocks as their strategy relies upon taking advantage of price fluctuations (or at least trying to do so).

Talking fundamentals, the healthcare ETF is quite attractively priced at the moment with a P/E of 17.8x and 8.8% annual expected 3-year EPS growth, as per State Street Global Advisors .

Within the index, there's a healthy blend of growth (for example UnitedHealth ( UNH )), dividend income (Johnson & Johnson ( JNJ )) and some deep-value names like Bristol Myers Squibb ( BMY ). You'll get exposure to serial acquirers such as Thermo Fisher ( TMO ), Danaher ( DHR ) without fretting about whether or not now is a good time to buy their shares individually.

The same ideology is applicable to the Dividend Aristocrats ETF, which is now priced at a P/E of 16.6x. While some of its holdings face challenges, you could view them as turnaround candidates besides owning the established low-risk giants such as Procter & Gamble ( PG ), PepsiCo ( PEP ). I expect a strong performance from the Dividend Aristocrats going forward, if and when interest rates settle down. Just like the XLV, this basket of stocks is priced at a discount to the overall market, despite its proven long-term resilience.

Relative Underperformance Confirms Low-Volatility Characteristics

When looking at the 3-year forward returns for the XLV, relative to the S&P-500 equal weight ( RSP ), we - unsurprisingly - notice cycles of out- and underperformance. Heightened volatility, stagflation, risk aversion are factors that will likely help drive outperformance for this ETF.

Investors who bought the XLV three years ago are now looking at an absolute 12% underperformance (with dividends reinvested). Compared to the ordinary S&P-500, the picture looks even worse because of the relentless rally in technology stocks.

It's remarkable, though, how history rhymes. Prior to the GFC, healthcare stocks were underperforming the market to an extent similar to what we're experiencing right now. However, relative performance is only worth watching if you manage to drastically outperform during tough periods in which the XLV handsomely succeeded.

From 2004 to the end 2015, healthcare stocks delivered an annual return of 9.3% versus 8.6% for the equal-weighted S&P-500. Even more impressive is the reduction in volatility: 13% annualized standard deviation versus 16.7%. Now, you wouldn't have expected a performance of this magnitude, especially when considering the periods of astounding relative underperformance from the above graph. Lagging the market by 70% over a three-year time span is far from an appealing result. And for sure, let's not forget that low-risk does not equal no risk. The below graphs depict the drawdowns since October 2013 and the rolling 1-year realized volatility.

You cannot time the next recession or the next Goldilocks-like environment. Neither can you 100% effectively predict tactical allocation. That's why I make monthly contributions of $2k to defensive ETFs. If I feel industrials have lagged the market, while healthcare stocks look fairly valued, I will just add more to my industrials ETF position.

I would not replace my existing defensive positions, which are supposed to have held up better in the down periods, with higher-beta stocks just for the sake of avoiding relative underperformance in a possibly new uptrend. It's always a matter of discipline when investing in assets that deliver high risk-adjusted returns. Periodical contributions and a focus on protecting your principal are what will make you stand out from the rest.

The Dividend Aristocrats and the healthcare sector will serve you well into the second half of 2023 and beyond as their constituents have pricing power, solid earnings and dividend growth, strong balance sheets and above all a high Return on Capital. A high ROC is the truth serum for long-time compounders.

The below table of McKinsey clearly demonstrates the value-creative traits that many of the above mentioned names possess.

Closing Remarks

To sum it all up, the past 3-to-5-year period of weak relative performance that Dividend Aristocrats and healthcare stocks have so far experienced should bode well for long-term risk-adjusted returns. Interest rates will likely plateau, underlying inflation for companies with pricing power can persist longer than anticipated and the combination of below-average and below-market valuations implies that investors have been looking beyond low-risk stocks. We believe this mindset will eventually change, like it did in the past.

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