Fallen stocks damaged by the pandemic have been rocketing upwards. But some of my favourite high-quality defensive shares have been sinking. Was I wrong to be so enthusiastic about those stalwarts, or is this a buying opportunity?
At the end of last year, my Motley Fool colleague Tej Kohli pointed out that investors have been shifting their money. And he explained that “rotation is the counter-movement of investor capital from one equity sector into another.”
Sinking quality stocks
Kohli reckons rotation often occurs between growth and value stocks. And I think we can see signs of that playing out in the American stock market. It is, after all, heavy with technology growth companies. We’ve also seen a bit of rotation from growth stocks here in the UK.
But we investors can see trends in the markets by keeping an eye on our own portfolios and watch lists. And I think we’ve maybe been seeing something of a rotation from over-priced quality stocks into lower-quality, cyclical stocks damaged by the pandemic.
I’m tempted to use that theory to explain the recent fall in quality shares, such as branded fast-moving consumer goods company Unilever (LSE: ULVR). The company scores well against quality indicators, but it’s pushing things to describe it as a growth business. City analysts expect a modest advance in earnings of a mid-single-digit percentage in 2022.
However, I’ve always liked Unilever because it operates a defensive, cash-generating business. The firm’s well-loved consumer brands tend to keep selling even during economic downturns. That’s why I reckon Unilever is a good candidate for a long-term holding period.
But there’s been a problem. For several years, investors pursued the so-called bond-proxy trade. In other words, they looked for alternative investments when interest rates declined. The returns from bonds and cash savings became pitiful. And people started buying defensive shares like Unilever for the shareholder dividends instead.
And the buying spree pushed up the share prices and valuations of my favourite defensive stocks such as Unilever. The stock has been weak since last autumn. But even now, I think the valuation looks full. With the share price near 3,821p, the forward-looking earnings multiple is just below 17 for 2022. That strikes me as quite high for a business with lacklustre anticipated earnings.
One factor putting pressure on the stock is the soaring value of sterling against the euro. Unilever reports in euros. However, I think it’s possible we could be seeing the start of an unwinding of the bond-proxy valuation premium as investors rotate to stocks recovering from the Covid slump.
Several other of my defensive favourites have been falling too. I’m thinking of names such as AstraZeneca, British American Tobacco, GlaxoSmithKline, National Grid, Reckitt Benckiser, Severn Trent, Sage and SSE. If these stocks keep sliding, they could reach a point where the value becomes compelling and a long-term investment could make sense.
However, my analysis might be wrong. And the falls could be due to other reasons relating to a deterioration of the prospects of the underlying businesses. Perhaps those reasons will emerge later. But I’m watching these shares closely for now.