According to Aaron Binsted, portfolio manager at Lazard Asset Management, defensive equities can be an appealing asset type for near pension phase and pension phase who are looking to minimise risk whilst reaping some returns.
“I really believe in the benefits of defensive Australian equities for those who are nearing their pension phase or are in their pension phase. These people want more certain returns, lower volatility and good levels of cash flow that they can depend on. So, for people who are seeking those attributes, I think that they’re people who should definitely look at defensive equities.”
He says it is important for later stage investors to consider diversifying their portfolio through the use of defensives, as over-exposure to high growth stocks could see them vulnerable to a market downturn.
“With a lot of people maturing through the superannuation system and moving to pension phase, I think that we as an industry are waking up to the fact that there’s more than just trying to achieve the highest return possible,” he says.
“The difference being that people have very different desires when they’re in their accumulation phase versus their pension phase.”
“If you’re still going to work for the next 20 years, it’s probably okay for you to take a bit more risk and weather some volatility because you’ve got a lot more time to contribute into your super. But if you’re in retirement, a draw down can really hit you quite badly and you may not have the ability to top that back up to rebuild your balance.”
“Some scenarios we’ve run indicate if an investor can limit their draw down from, say, a 30 per cent draw down to a 10 per cent draw down, it can give them up to six years extra pension income. So, we think it’s a material issue for people to be considering.”
Mr Binsted says traditional valuation metrics suggest that markets globally are overvalued, indicating we may be in the late cycle of a bull market and future volatility is on the horizon.
“When we look at investment markets globally, we would say that they look quite stressed in valuation terms,” he says.
“There are a few things we point to, to indicate that. For example, the biggest market in the world, the US equity market looks very high on traditional valuation metrics as it, this year, hit a record of market capped at GDP, which is one of one of those big picture valuation metrics.”
“As well as this, a lot of fixed interest markets are trading on negative interest rates, which is very unusual in an historic context. So, that paints an environment of stretched valuation.”
“Australia is not as bad as the US, but we do think it looks moderately overvalued, whereas we’d say the US looks quite overvalued. But we do have some risks here, which is why we think it is an appropriate time for defensive equities,” he asserts.
He says there are two means through which investors can best utilise defensive equities.
- Consider the valuation of company or stock
“We won’t buy a company that we think is overvalued, even if it might have great dividends or great growth. That helps us to be defensive,” he says.
“We’ll only buy companies with strong, proven business models and good cash flows that aren’t too geared. So, at the stock level, we’re typically lower risk.”
- Allocate some of the portfolio to cash
“In a market downturn, cash defends its value and doesn’t fall,” he puts simply.
Mr Binsted warns investors of supposing all equities within traditionally defensive asset classes, such as gold or infrastructure, are secure defensive investments.
“You can’t apply a simple formula, and it’s not the case that the same thing will always be defensive,” he says.
He uses the example of property trusts to showcase how a conventionally ‘defensive’ asset can be subject to debt cycles and adverse board policies that can shift it in and out of the category.
“Property trusts are traditionally seen as very defensive assets. They have high revenue certainty and pay good dividends. Before the GFC, they had far too much debt, their payout ratios were way too high, and we subsequently saw that in the GFC, they had to cut their dividends and raise equity,” he says.
“For about the next four to five, even six years after the GFC, you did get those attractive characteristics back. Their balance sheets were sensible, they had good payout policies and they were great defensive securities to hold.”
“However, in 2015, some of the old bad habits started to creep in. They started to take on more debt, their dividends got a bit aggressive again, and there was, perhaps, some purchasing of assets at valuations that were too aggressive. So, while it was nowhere near as bad as pre-the GFC, some of those bad habits were coming back.”
“That’s a good example of one asset that should be, in theory, ‘always a great defensive’ but, because of these vagaries of debt cycles and aggressive capital policies by boards, they can move in and out of that category.”
He says pension age investors must seek professional advice and look for accredited information sources to verify whether a stock is truly a good quality defensive and, therefore, worth investing in.
“You really need to do that fundamental bottom-up work to know which part of those cycles you’re in and you need to approach the right people to have the tools to do that work,” he concludes.