Is It Time to Stop Playing Defense In Stocks?

US News

Many investors believe global economic conditions are improving. Yet, their portfolios are still positioned with a Great Recession-induced defensive bias, potentially reducing the returns they could earn from sectors that typically perform well during periods of economic growth.

For both the U.S. and international equity markets, defensive sectors such as utilities, pharmaceuticals and consumer staples, which have served as "bond proxies" for investors seeking yield, are now valued at significant premiums to their long-term, historical averages. By comparison, equity valuations are relatively attractive in the more economically sensitive areas of the market -- such as consumer discretionary, industrials and materials -- and even the long-maligned financial services sector.

The rationale for a move into defensive areas of the market was sound several years ago. Disappointing economic data combined with heightened political uncertainty and other macro factors compelled equity investors to take a cautious approach. Through the first quarter of this year, as global equities rallied, investors continued to pile into defensive stocks, drawn to the relative safety of these companies. Unfortunately, in the current market environment, there are risks inherent in this flight to safety as premium valuations and an overcrowded trade leave little margin for error.

Let's look at an example of two companies -- one defensive, the other cyclical -- and compare them. Nestlé, one of the world's largest food and beverage companies, currently trades at a multiple of 18 times 2013 earnings. The company has an earnings-per-share growth rate of 9 percent and a dividend yield of 3.3 percent. For the last 10 years, Nestlé's average price/earnings multiple has been 15.4, which means at today's levels, the company is trading one standard deviation above its long-term average. That's a 16 percent premium. Investors are paying a premium for the perceived safety of a company that is expected to grow earnings by 9 percent on low single-digit sales growth.

On the other hand, Adecco, a temporary and permanent staffing company, is currently trading at 16.8 times 2013 earnings, which are expected to grow 62 percent year-over-year. Adecco pays a 3 percent dividend. After a nice run up in the share price this month, the company is still trading near its long-term price/earnings multiple, despite the better-than-average growth potential. While the company is recovering from depressed earnings, current valuations are not by any means stretched. Going forward, investors have the potential not only for higher earnings growth, but also multiple expansion, similar to what we have seen in more defensive sectors of the market.

Since the beginning of the year, global economic indicators have been mixed but we have been observing a general improvement overall in global economic activity. In June, according to Absolute Strategy Research, four of the five major indicators in the Global Manufacturing Purchasing Manager's Index rose, suggesting that a more broad-based improvement in the global economy is underway. Additionally, European PMI's surprised to the upside, opening the possibility to an economic recovery in the second half of this year.

Performance of cyclical or economically sensitive companies and industries tend to move in lockstep with leading economic indicators. Investors who believe that the global economy is on the mend should consider altering the composition of their equity portfolios to take advantage of the attractive valuations, greater growth and capital appreciation potential of cyclical and financial services stocks. While there is a place for high-dividend, income-producing stocks in every portfolio, it's time for the cyclical stocks to take the wheel.

With more than 30 years of investment experience, Marc Halperin co-manages the Federated International Leaders Fund. He is responsible for portfolio management and conducts global equity research focusing on the financials, industrials and consumer discretionary sectors. His fund owns shares of securities mentioned above.

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