Sector Watch: Spotlight on Defensive Strategy

About four and a half years ago, Folio Investing launched an equity (e.g. stock) portfolio that focused on reducing the impact of market volatility.  So-called defensive stocks are those which tend to be fairly insensitive to the mood of the market as a whole.  Conventional wisdom suggests that demand for band-aids, electricity and paper does not go up when the market is exuberant, but neither does it collapse when the market swoons.  The conventional wisdom also suggests that these stocks will tend to under-perform the broader market during rallies and, over the long-term, that a portfolio of these stocks will deliver modest returns.  Our research suggested, however, that it was possible to create a portfolio of defensive stocks that would provide returns to keep up with rallies in the broader market, while still substantially reducing the impact of market volatility.  Folio Investing launched theDefensive Strategy Folio that incorporated this research on February 28, 2008.

Performance

From February 28, 2008 through September 5, 2012, the Defensive Strategy Folio has provided an annualized return of 6.28% vs. 2.72% per year for the S&P 500 (including dividends).  The Defensive Strategy Folio has performed well over a 4.5-year period during which the S&P 500 has struggled.  This is what we expect for a defensive strategy.  What is truly notable, however, is that the Defensive Strategy Folio has kept up with the robust rally in the S&P 500 over the past three years as well.  The chart below shows the total return for an investment in the S&P 500, assuming dividends are reinvested, from August 31, 2009 through August 30, 2012.  Over the period, the S&P 500 has returned a cumulative 46.7% (annualized return of 13.6% per year).  Over the same three-year period, the Defensive Strategy Folio has slightly out-performed the S&P 500 with a total return of 48.3% and has done so with less volatility.  As the chart below illustrates, the Defensive Strategy Folio has followed the broad rally but has not swung up or down as much as the S&P 500 during short-term rallies and drops.  The chart of the Defensive Strategy performance is for funded performance for an account maintained at Folio Investing.

Defensive Strategy Folio vs. S&P 500 (8/31/2009-8/31/2012)

There are a number of possible explanations for the substantial out-performance of the Defensive Strategy since it was launched in February of 2008.  Certainly, there is an element of chance.  This Folio was introduced shortly before one of the worse market crashes in history and defensive industries tend to thrive in these conditions.  Our research in 2007 suggested that the Defensive Strategy would out-perform in down markets but also would out-perform the S&P 500 across a range of market conditions.  The fact that the Defensive Strategy Folio has slightly out-paced the S&P 500 during its impressive three-year rally supports our conclusions.

Strategy Overview

The Defensive Strategy Folio is not simply a collection of stocks picked from defensive sectors.  A key part of our analysis was to combine securities in the Folio that provided effective risk offsets.  In other words, these stocks were selected both on the basis of their individual attributes, and on how well they worked together to mitigate risk.  This was accomplished using a sophisticated statistical analysis that accounts for the correlations and risk levels of each stock on a trailing historical basis and using forward-looking Monte Carlo simulations.

On an individual basis, the stocks that comprise the portfolio tend to have low Beta, a statistical measure of how much the returns on a stock are driven by the broader market.  Defensive stocks tend to have low Beta.  The current Beta for the entire Folio is 73% as compared to 100% for the S&P 500.  There is a growing body of research that finds that low-Beta stocks out-perform their higher-beta counterparts (which are often ‘growth’ stocks) over the long run.  This research supports our own findings, albeit on the basis of a different line of reasoning.

Commentary: The Case for the Defensive Strategy

There are a variety of reasons why the type of strategy used in this portfolio may be attractive in the future.  First, while the economy is recovering from a deep recession, the economic growth as we emerge may continue to be modest.  In addition, the overhang of consumer debt may substantially limit the rebound of discretionary consumer spending.  For these reasons, companies which provide necessary basic products and services are quite likely to out-perform relative to stocks of companies that sell discretionary products.  While this narrative is plausible, any type of economic forecast is fraught with uncertainty.  The Defensive Strategy Folio allows investors to participate in economic recovery and growth, as we can see by the performance over the past three years, as well as providing some protection from market volatility.

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The Cost of Complexity

In [Donald] Yacktman's view, businesses with both low capital intensity and low cyclicality (Coke: KO, Pepsi: PEP, and P&G: PG are the specifics mentioned) are likely to earn the highest returns.

The benefits owning shares in quality businesses long-term (especially if bought when occasionally selling at a fair or better than fair price) comes down to potential returns relative to risk.

Simple to understand? Certainly. Easy to implement as a core investing approach? A bit less so.  

The evidence to support the merits of owning shares in these kinds of businesses long-term isn't hard to find nor is it particularly complicated. A simple insight can sometimes trump details and complexity. When it occasionally does, use it. What's simple can beat the complex and, in fact, often does.

Yet simple isn't always better. It is just that what is used should be neither more simple nor more complicated than it need be.

It's possible, of course, to make things too simple.

Science views complexity as a cost. That additional complexity must be justified by the benefits. 

"In science complexity is considered a cost, which must be justified by a sufficiently rich set of new and (preferably) interesting predictions..." - From the book "Thinking, Fast and Slow" by Daniel Kahneman

Well, investors ought to view complexity in a similar way. 

Investing is always about getting the best possible returns, at the lowest possible risk, within one's own limits. Since it is already inherently enough of a challenge, there's no need to make it more so by adding unnecessary complexity. Don't use calculus when arithmetic will do the job. Save the more powerful tools for when they can actually add value (and especially avoid some of the worse-than-useless overly complex theories taught by modern finance).

Now, just because something is relatively simple doesn't mean lots of homework isn't necessary.

There absolutely is lots of hard work involved. 

The reason for and advantage of owning shares in some of the quality franchises -- superior returns at less risk if bought well -- is clearly not all that difficult to understand. Having enough discipline, patience, and the right temperament to stick with it is the tougher part. 

Well, that and maybe not becoming distracted by the various forms of investing alchemy cloaked in incomprehensible faux sophistication: 

"...most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'." - Warren Buffett in the 1987 Berkshire HathawayShareholder Letter

Quality stocks. Less drama. Little mystery. Effective. 

Think of them as the "two aspirins" of investing. 

I'm sure that many will still choose to own shares of the highest quality stocks primarily for "defensive" purposes. I doubt that changes anytime soon. Somehow, the thinking goes, they'll jump in and out while not having mistakes and frictional costs to subtract from total return. Sounds good in theory. I'm sure there are even some who can make that sort of thing work for them. There are likely even more who incorrectly think they can.

So, despite the evidence, investing in high quality businesses long-term remains an approach that's still not frequently employed.*
(I mentioned in the previous post that Jeremy Grantham has described these high quality businesses as the "one free lunch" in investing.)

It's a subject I've covered many times on this blog (okay...maybe too many times based upon the number of related posts I have listed below) because it just happens to have been and remains a cornerstone of investing for me.

Unfortunately, investors need more patience now compared to when valuations were quite attractive not too long ago (though at least it's not nearly as bad valuation-wise as it was a decade or so ago). Most of the best quality enterprises are rather fully valued right now.
(Over the shorter run -- less than five years -- anything can happen as far as relative performance goes. It's the longer time horizons -- more like twenty years or so -- that the "offensive" merits of high quality businesses become more obvious. A full business cycle or two. I realize that some, or maybe even many, market participants consider five years to be longer term these days.)

Still, it makes sense to embrace any simple, understandable, yet effective method of delivering above average risk-adjusted returns while generally avoiding the esoteric.**

Finally, the assessment of risk is necessarily imprecise and is certainly not measured by something like beta. Real risks does not lend itself to the all too popular quantitative methods. What can be measured, should be, but much of the important stuff can't be measured all that well. It requires a mixture of both quantitative and qualitative.

"You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - Charlie Munger in this speech at UC Santa Barbara

When it comes to managing risk (and many other things), it's often a mistake to allow the less important but easy to measure stuff to triumph over what's more meaningful if tougher to measure. 

Adam

Long positions in KO, PEP, and PG established at much lower than recent market prices. No intention to buy or sell shares near current valuations.

Related posts:
The Quality Enterprise: Part II - Aug 2012
The Quality Enterprise - Aug 2012
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Grantham: What to Buy? - Aug 2011
Defensive Stocks Revisited - Mar 2011
KO and JNJ: Defensive Stocks? - Jan 2011
Altria Outperforms...Again - Oct 2010
Grantham on Quality Stocks Revisited - Jul 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - Nov 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - Apr 2009
Best and Worst Performing DJIA Stock - Apr 2009
Defensive Stocks? - Apr 2009

* To me, the shares of many of these businesses are not especially cheap these days even if they have been at times over the past few years. It's worth waiting for a good price then acting decisively when valuation is attractive. Since each is unique, the necessary homework to build some depth of knowledge and understanding can be done while waiting for the right price. These may be lower risk but they're certainly not no risk. Margin of safety still matters. There's no way around the preparation and patience required in investing. After figuring out what's attractive at a certain price lots of waiting is inevitably necessary.
** Some may become bored by the straightforwardness. A few may even choose more complicated, high risk journeys just to enhance the challenge. Long-term Capital Management (LTCM) comes to mind. Charlie Munger said it best in this 1998 speech:

"...the hedge fund known as 'Long-Term Capital Management' recently collapsed, through overconfidence in its highly leveraged methods, despite IQ's of its principals that must have averaged 160. Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger's 1998 speech to the Foundation Financial Officers Group

Uncomplicated, understandable, yet effective ways to produce attractive risk-adjusted returns should be embraced. Sophisticated or esoteric methods, especially those involving leverage, should not. Best to be wary of overconfidence in any profession. It can get even the most talented into trouble.

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Ingens, Panaroma Activity 2 Show

KUALA LUMPUR: Shares of Ingenuity Solutions Bhd fell 25.7% in afternoon trade on Tuesday ahead of a press conference called by substantial shareholder Chin Boon Long to clear the air over the recent developments.

At 4.19pm, the share price of the ACE Market-listed company was down nine sen to 26 sen. There were 96.36 million shares done.

Ingenuity-WA fell 1.5 sen to nine sen with 39.92 million units transacted.

The FBM KLCI slipped 0.27 of a point to 1,653.63. Turnover was 1.14 billion shares valued at RM1.089bil. There were 238 gainers, 468 losers and 320 counters unchanged.

Ingenuity, a tech firm which made a net profit of RM3.2mil in its latest quarter, has attracted trading interest in recent days following events leading to the announcement of a possible takeover of Ingenuity.

In the latest development, Chin was quoted saying on Tuesday he would be addressing the media and stakeholders in his personal capacity. The press conference will be held Wednesday at 10.15am in Federal Hotel, Jalan Bukit Bintang, Kuala Lumpur.

He sent out an invite to the media and hopes to extend the invite to all shareholders of Ingenuity Solutions, 1 Utopia Bhd as well as other concerned stakeholders. Chin is also the managing director of 1 Utopia.

To recap, last Thursday, Ninetology Marketing Sdn Bhd, a relatively unknown technology firm with a paid-up capital of RM2, announced it had "ready funds" to take over Ingenuity.

Ninetology had offered to acquire a 39.44% stake in the company at 55 sen per share. If the deal goes through, this would trigger a mandatory general offer to acquire all the remaining shares Ninetology has not already owned in Ingenuity.

Ingenuity it had received an offer letter from Ninetology to purchase all of the shares held by Chin, Firstwide Success Sdn Bhd, Landasan Simfoni Sdn Bhd and Titanium Hallmark Sdn Bhd amounting to a total of 214,297,656 shares, representing 39.44% of the total equity interest of Ingenuity, at an offer price of 55 sen per share.

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LOL, Ingens is another clown in the Ace circus. Offer letter at 55 sen yet the counter dropped to the lowest price of the day today, 22.5 sen. Nobody believe the deal will go through I guess whatever the press conference tomorrow will say. Any chance for CONTRA trades tomolo ?

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