Defensive plays will still pay

Logic doesn’t feature highly on the list of imperatives when it comes to the collective psyche of markets.

Just consider the paradox in which we find ourselves right now. There’s a major rally on the domestic stockmarket being driven by a seemingly insatiable demand for defensives – the stocks you buy when you are worried about a stockmarket decline.

That defensive rally pushed the All Ords through 4,900 this week, above the level some pessimistic analysts were tipping for December 31. And we are just one month into 2013.

While it’s never advisable to throw logic to the wind, it is also worth remembering that a sudden turnaround in market sentiment can have a self-fulfilling effect on the broader economy.

For five years, the world has been subjected to constant warnings of chaos and impending economic doom. That has driven a universal deleveraging program on a scale rarely witnessed as the developed world restructured its finances following a debt binge during the first decade of the new millennium.

Consumers and corporations embarked on a massive balance-sheet clean-up, paying down debt and replacing spending with savings. Governments only recently have joined the party.

It is now apparent that cycle, at least for consumers and corporates, may have run its course given the more encouraging news out of America and Europe as fears recede of a cataclysmic sovereign debt crisis.

The voracious appetite for domestic yield stocks that began midway through last year largely has been driven by interest rate cuts. Investors moved their cash out of government bonds and term deposits into high-yield defensive equities.

As the rate cuts continued, the shift accelerated and much of the recent buying has been driven by speculation of further reductions in official cash rates. Now, however, there are fears that the rally is overdone.

Stock prices, the argument goes, have outpaced earnings growth by a country mile. It is time for a correction. A quick look at the price earnings multiples of some of our most popular companies certainly indicates that many now are in overpriced territory.

But as Adam Carr points out today (Don't buy the CBA sell story), and as I alluded to last week in a story on Wesfarmers (Reading between the broker lines), selling out of a high-yield defensive stock now requires you to have an alternative. And while a pullback on equities markets is on the cards, particularly if the earnings reporting season does not meet expectations, most of those big defensives will maintain their dividends.

So if it is yield you seek, rather than short-term trading profits, those yields still will be paid. Bear in mind too that any correction is likely only to be a temporary respite in an ongoing, but possibly bumpy, rally that should extend through 2013.

That’s not to say the banks or any of the other defensives like Telstra and the supermarkets are a screaming buy right now. They are more likely to be better value if and when prices dip during the half-year reporting season.

Let’s have a look at some of those defensives.

As Adam points out, our banks are priced between 11.6 and 14.6 this year’s earnings, with NAB at the bottom and Commonwealth leading the pack.

It is worth bearing in mind that the 20-year average for the Australian market is 14.4, and the general market is now sitting around that level. While that has the analysts worried, it is worth noting that it has not yet outpaced the average.

There is also a strong argument to be made that in a low interest rate environment, there is a strong justification for the P/E ratio to outpace the average.

While on the banks, it is worth noting as well that while the consensus is that credit growth will be anaemic, the banks actively are reducing costs. On top of that, the more settled global environment and the Federal Government’s move to allow the introduction of covered bonds last year has also substantially cut funding costs. So don’t bet on an earnings slump this year.

Defensive Offensive

Telstra

Telstra has been a star performer for the past 18 months. After plunging well below $3 in 2011, it this week hit multi-year highs of $4.67.

With a price earnings multiple of 16.9 times current earnings, Telstra superficially would appear expensive.

On capital gains alone, it has delivered shareholders a whopping 34% since this time last year. It is yield that has driven the company’s dramatic re-rating.

Despite the massive share price lift, Telstra is still delivering a net yield of 6%, which Bloomberg estimates is a fully grossed up return of 8.59%.

Citigroup recently declared the telecom as one of the world’s most expensive telcos but believed the premium was justified.

“Telstra is at the top of its game,” the broker said. “The premium valuation reflects the market’s appreciation of its class-leading operational and financial performance. The certainty and size of the dividend continue to offer an acceptable risk/return. On this basis we view the stock as fair value (based on the current interest rate outlook).”

Woolworths

Bloomberg has the fresh food operator priced at 17.6 times current earnings. On a net basis, Woolies delivers a yield of 3.95%. Gross that up and it comes to a more respectable 5.69%.

Despite the pricey nature of the retailer, quite a number of analysts still rate it a buy. Its second-quarter sales numbers hit the market this morning (Wednesday) with growth, excluding petrol, of more than 6% expected.

Improved marketing, continued domination of liquor, store expansion and reduced effects of food deflation are expected to flow through to earnings.

The company has forecast net profit after tax growth of between 3% and 6%, something that has endeared it to the analysts.

JP Morgan recommends Woolies as an overweight addition to a portfolio, although its target price of $31.25 is a discount to the retailer’s current level of $31.65.

Wesfarmers

The Perth-based conglomerate has delivered handsomely for investors in the past year with returns of around 30%.

Like Woolies, it has significantly run ahead of the general market driven mostly by its strong performance in Coles, which has seen its fortunes dramatically improve under Wesfarmers’ ownership.

Coles, Bunnings and Kmart all are performing well while Target remains a problem. But its biggest issues lie in its resources division. Coking coal prices have dropped 26% on a weighted-average basis in the December quarter to a level that impacts on Wesfarmers' Curragh mine.

Priced at 20.7 times current earnings, according to Bloomberg, it clearly has outpaced expected earnings. But even on these levels it is delivering a dividend yield of 4.25%, which Bloomberg estimates is a grossed-up return of 6.16%.

JP Morgan has a price target on the group at $34.45, significantly below its current levels of $38.25. Not surprisingly, it is recommending an underweight position.

But again, that is driven by recent share price appreciation rather than a poor outlook for the company.

BHP

The Big Australian has been at the forefront of the resources boom for more than a decade, notching up massive profits.

But for years there has been shareholder discontent over a predilection to invest returns for future earnings rather than delivering to current shareholders.

That all changed last year when a sudden slump in commodity prices forced a strategy rethink and a number of mega-projects were put on ice.

At 37.50 BHP’s share price is still below this time last year, although it has recovered strongly from its $31.10 low in July.

It is priced at about 13.5 times current earnings, which is high by historic standards. Traditionally resource companies traded at a significant discount to industrials because of the short-lived nature of resources booms. That rationale changed with the emergence of China.

Like many other majors, BHP is being driven by a strong regime of cost cutting. Capital expenditure programs however limit the dividend and even on a fully grossed-up level, BHP will be delivering only around 4.06%.

UBS, however, rates BHP as a buy, slapping a valuation on the company of $40.61.

Minimising losses

Retail investors usually are inundated with strategies for either supercharging gains through contracts for difference, or hedging strategies using options.

Right now, wealth managers are urging hedging strategies in the event of a market correction.

With the Commonwealth, you can buy a put option at $62, and pay around 50c. If CBA shares fall substantially, you can sell your stock at that level.

Alternatively, you can sell a call option at around $67 and pull in about 30c a share. That may deliver you an extra 30c a share, which wouldn’t cover a lot in the event of heavy losses. But you would be capping your CBA shares at $67.

The general mood is that a consolidation in the market is just around the corner. But it is likely to offer a chance for further buying in the early stages of a bull market.