Topical themes from Dunedin Income Growth: When are defensive sectors not defensive?

Stock markets have been volatile since the start of the year, with the Ukraine crisis and interest rate rises combining to unnerve investors. At Dunedin Income Growth Investment Trust (DIGIT), we were already cautious in our positioning, and these developments do little to make us shift our views. However, we also need to be careful that our defensive companies are truly defensive. 

For some time, defensive stocks have been traditional industries such as healthcare, where demand does not vary with the economic cycle. However, in this recent period, energy has also proved defensive as oil prices have risen due to geopolitical uncertainty. Equally, it is harder to argue that technology is as cyclical a sector as it once was. For many companies, technology is a crucial part of how they service clients, how they create efficient operations and how they manage their costs. 

Against this backdrop, this sector-based view on defensive assets is less useful than it has been in the past. In reality, resilience comes from the characteristics of individual companies rather than their sector classification. Companies within the same sector can have very different demand drivers. 

In our view, ‘defensiveness’ comes down to a company’s competitive differentiation and sustainability. Companies need pricing power, a strong economic moat and barriers to entry (such as its relationships with its customers). A strong balance sheet is also important. Some of these will be in traditional sectors such as healthcare – AstraZeneca, for example, has patents to protect its revenue streams and its demand does not vary significantly through the cycle. However, we can find these characteristics in other sectors as well.  

More recently this has meant adding to companies such as RELX, the information and data publishing business which sits within the media sector, but is a very defensive business in our view. It has a large subscription-based revenue stream that is diverse and recurring. Its service is critical to its users, which translates into tremendous visibility and strong cash flows. This has funded consistent growth in RELX’s dividend alongside generous buybacks with surplus cash. 

A crisis for ESG?

 The recent market volatility has seen many so-called ‘sin’ sectors perform better, including traditional fossil fuel and defence companies. This has led to some suggestion that fund managers re-think their adherence to ESG (environmental, social and governance) metrics when making investment decisions. 

The weight placed on ESG considerations depends on the investor’s time horizon: if it is less than a year, the company’s performance is much less relevant, only whether the stock is mispriced. However, if an investor wants to own a company through the ups and downs of the cycle, it is vital to consider how it manages its ESG risks. 

Recently, there has been strong performance from companies with a weak ESG focus. It is inevitable that there will be times when certain companies do well, but these same companies still face some considerable risks, both in terms of environmental policy, and over social and governance issues. This could exert a drag on returns. For example, defence companies are doing well today, but in the longer term they may have challenges in terms of pricing long term supply contracts effectively, handling government interference and managing bribery and corruption risk, quite aside from the moral implications of their products.

If anything, the developments in Russia and Ukraine highlight the importance of incorporating ESG considerations into investment decision-making. In the short-term the crisis has been good for companies that sell hydrocarbons, but in the longer-term it will accelerate the shift towards renewables and low carbon energy in a way that policy focused on climate change has not yet delivered. 

If we look at social elements, the change in attitudes has been remarkable. The pressure on corporates to do the right thing has never been greater and many have pulled out of Russia wholesale. Showing the importance of “doing business in the right way” to ensure support from key stakeholders and customers. It has shown also the more old-fashioned importance of doing business with the right people in the right places and managing the essential governance risks effectively.

Effective engagement

While many of the ‘sin’ sector stocks remain off-limits to us, given the range of exclusions we have on the DIGIT portfolio, there will be some companies where the ESG score is middling and where we believe we can make a real difference to a company’s performance. This is where our engagement programme comes in.  

We meet corporate management frequently. Discussions on ESG factors are integrated into those meetings. These factors have become intertwined with the day to day running of businesses in all sectors and are crucial to the risks and opportunities they face. We also have regular dedicated meetings with board members on governance – including remuneration, board structure, senior non-executive appointments, plus voting at AGMs. 

There is a layer of engagement beyond this, where we look to drive certain outcomes in companies and improve the way they’re run. For our priority engagement list, we set out a clear process showing those companies what they need to do to improve. We work with ESG specialists internally to set those priorities and help companies respond. 
One recent engagement was with Total Energies, a company where the transition to a lower carbon future is critical. We engaged with the company, along with third parties such as Climate Action 100, to ensure progress to limiting global warming to 1.5 degrees. The fabric of the company and its ESG footprint are intertwined and it’s one of the few global energy companies whose efforts on decarbonisation enable us to own it in the portfolio. 

The health of the corporate sector

Volatile stock markets belie a relatively positive picture from the corporate sector. Earnings expectations have been moving higher. In their first quarter reports, companies continue to report a tricky environment, but say they are managing it well by putting up prices and managing costs.

There is still a positive annualisation effect from Covid in 2021, particularly for some of our consumer-facing companies which last year were dealing with markets that were locked down. Companies in the DIGIT portfolio are generally navigating the environment successfully and we have had few negative surprises from this quarter’s earnings season. This gives us confidence in the resilience of future dividends and earnings from the portfolio companies today.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.

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