Finding Defensive Stocks Ripe for Recovery

31 August 2021

4 min read

Kent Hargis, PhD| Chief Investment Officer—Strategic Core Equities; Portfolio Manager—Global Low Carbon Strategy

Ian McNaugher, CFA| Research Coordinator (US) and Senior Research Analyst—Strategic Core Equities

Sammy Suzuki, CFA| Head—Emerging Markets Equities

Defensive stocks are often misunderstood. In recent years, even when they have delivered strong and steady earnings, returns have disappointed. Innovation often goes unappreciated. But we believe the disconnect between resilient businesses and share prices is unsustainable and ripe for reversal.

Since the beginning of 2020, the market has paid up for companies with strong sales growth. Share prices of companies in higher-growth industries and in some value industries have dramatically outpaced their earnings growth. Yet despite resilient earnings and attractive valuations, defensive companies have been left in the dust through the uncertainty of the pandemic—a time when their relatively stable businesses should have been prized (Display).

Defensive Stocks: Modest Share Gains Despite Relatively Stable Earnings

Select MSCI World Industries (Percent)

The largest gap between price change and earnings change in 2021 is in defensive sectors.

Past performance does not guarantee future results.
Data is for 2021.
*Measures change in price and estimated 2021 earnings from January 2020 to June 2021
As of June 30, 2021
Source: FactSet, MSCI and AllianceBernstein (AB)

After a period of underperformance for defensives, a broadening market can represent real opportunity. Defensive sectors continued to grow earnings and cash flow during the period when the market chose not to reward them with higher prices. Simply put, there are some high-quality, defensive companies with stable businesses and cash flows that are currently available at very attractive prices.

Sector X: Victim of Historical Bias?

Investors may be shunning sectors with attractive fundamentals because of preconceived notions, in our opinion. For example, consider a traditional defensive sector that we will call sector X. In this sector, average earnings and dividend growth are as strong as they have been in over a decade, around 5%. And that’s expected to continue for the foreseeable future. Yet the sector’s shares gained a paltry 0.5% in 2020 compared to a gain of over 18% for the S&P 500.

Earnings and dividend growth expectations for the mystery sector are historically high and expected to remain so for several years (Display, below left). And innovative companies in the group are growing even faster.

What Sector Offers Solid Dividends and Cheap Valuations?

Left: shows 25 years of steady earnings. Right: Sector trading at 15% discount, usually 3% premium.

Past performance does not guarantee future results.
As of June 30, 2021
Source: Bloomberg and AllianceBernstein (AB)

Most compelling trait? Its bargain-basement status. Sector X is trading at a 15% discount to the S&P 500 instead of its average 3% premium since 2008 (Display, above right). This sector underperformed the S&P 500 by 53% from March 9, 2020, to August 9, 2021—the worst relative peak-to-trough performance since the 1990s tech bubble. We think it may be time for a comeback.

So why have investors avoided a sector with consistent and improving characteristics like this? We think it’s because investors have focused primarily on hypergrowth companies, recovery plays and inflation beneficiaries, none of which fit this category. But in fact, we believe there are many exciting changes and themes going on under the hood of this underappreciated sector.

Utilities: Not Just a Bond Proxy Anymore

Sector X is, of course, utilities. Historically, our grandparents owned them for their defensive characteristics and dividends. Today’s investors might consider utilities to be boring bond proxies, especially when compared to high-flying media and technology pioneers. But we think the stereotype is overstated and there are several good reasons to take a fresh look at utilities today.

Utilities are the agents of change for the clean energy transition. As power-generating companies build out renewables as well as related transmission and distribution infrastructure, many benefit from tax incentives and continued political support to help states meet carbon goals. Renewables are also getting cheaper and, in wind’s case, more effective as technology improves. We believe the increased focus on climate change and reducing carbon emissions globally will deliver long-term benefits for utilities companies that are proactively positioned for the renewable energy revolution.

Politics aren’t a problem for this group either. The current bipartisan US infrastructure bill could be an upside for investments in transmission and renewables, and could perhaps even expand tax credits. Plus, the US wind corridor runs through mainly Republican states, so the technology build-out is likely to continue under any political constellation. And regulated utilities are protected from higher corporate taxes, too, as they are generally passed through to customers.

To invest in US utilities, however, selectivity is critical. For example, many utilities operating in wildfire-prone areas are a challenging investment at best. They are highly volatile and trade at steep discounts to peers. And even though many areas have laws protecting utilities from liability unless they are found negligent, they still sell off when wildfires occur. Equity investors should look for utilities with high-quality businesses and stable cash flows that trade at attractive prices, in our view. While it’s difficult to time when a change in sentiment toward utilities will develop, we believe the sector’s defensive properties combined with attractive valuation are rather compelling.

Beyond utilities, we believe that focusing on quality, stability and price is a good strategy for finding defensive stocks across sectors. In our view, active defensive portfolios based on these principles should have an advantage versus quantitative or passive approaches, which often include lower-quality businesses or expensive stocks. And by identifying innovators that are changing dynamics in diverse industries, investors can capture resilient return streams that also help reduce downside risk over time.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

About the Authors

Kent Hargis, PhD

Kent Hargis is the Chief Investment Officer of Strategic Core Equities. He created the Strategic Core platform and has been managing the Global, International and US Strategic Core portfolios since their inception in 2011. Hargis has also been Portfolio Manager for the Global Low Carbon Strategy Portfolio since 2022. Previously, he managed the Emerging Portfolio from 2015 through 2023. Hargis was global head of quantitative research for Equities from 2009 through 2014, with responsibility for directing research and the application of risk and return models across the firm’s equity portfolios. He joined AB in 2003 as a senior quantitative strategist. Prior to that, Hargis was chief portfolio strategist for global emerging markets at Goldman Sachs. From 1995 through 1998, he was assistant professor of international finance in the graduate program at the University of South Carolina, where he published extensively on various international investment topics. Hargis holds a PhD in economics from the University of Illinois, where his research focused on international finance, econometrics and emerging financial markets. Location: New York

Ian McNaugher, CFA

Ian McNaugher is a Research Coordinator (US) and Senior Research Analyst on the Strategic Core Equities investment team, covering multiple industries, including US utilities and aerospace & defense. Previously, he served as a research analyst on the Value Equities team, and before that served as a generalist and portfolio analyst for the Strategic Core portfolios, dating back to the inception of the platform in 2011. McNaugher joined AB in 2006, originally working in portfolio management and operations. He holds a BA in economics and English from Bucknell University and an MBA in finance from the Leonard N. Stern School of Business at New York University. McNaugher is a CFA charterholder. Location: New York

Sammy Suzuki, CFA

Sammy Suzuki is Head of Emerging Markets Equities, responsible for overseeing AB’s emerging-markets equity business and instrumental in the formation and shaping of AB’s Emerging Markets Equity platform. He was also a key architect of the Strategic Core platform and has managed the Emerging Markets Portfolio since its inception in 2012, and the Global, International and US portfolios from 2015 to 2023. Suzuki has managed portfolios since 2004. From 2010 to 2012, he also held the role of director of Fundamental Value Research, where he managed 50 fundamental analysts globally. Prior to managing portfolios, Suzuki spent a decade as a research analyst. He joined AB in 1994 as a research associate, first covering the capital equipment industry, followed by the technology and global automotive industries. Before joining the firm, Suzuki was a consultant at Bain & Company. He holds both a BSE (magna cum laude) in materials engineering from the School of Engineering and Applied Science, and a BS (magna cum laude) in finance from the Wharton School at the University of Pennsylvania. Suzuki is a CFA charterholder and was previously a member of the Board of the CFA Society New York. He currently serves on the Board of the Association of Asian American Investment Managers. Location: New York

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