Defensive stocks have been relatively unpopular among investors in the past year. In that time, growth shares have been in the ascendency. As a result, their valuations have surged to exceptionally high levels in some cases.
However, those valuations may not take into account risks such unforeseen challenges in vaccine rollouts, or the long-term economic implications of Covid-19’s impact on employment levels and consumer confidence. Therefore, defensive shares with growing dividends, such as BAT and Pennon, could offer relatively attractive investment prospects.
A lack of excitement about defensive shares
Companies with defensive credentials, in terms of their performance being less positively correlated to the economic outlook than index peers, usually lack the excitement of fast-growing businesses. Hence their apparent lack of appeal during the current bull market, where a vast improvement in risk appetite among investors has been a key driver of stock market valuations.
At the moment, investors seem to be ignoring problems such as rising unemployment, weak consumer confidence and the potential for further Covid-19 issues because of factors including monetary policy stimulus.
As a result, defensive stocks seem to be surplus to many investors’ requirements. Evidence of this can be seen in BAT’s share price decline of 21% in the past year, while Pennon’s stock price has fallen 13% in the same period.
However, the past performance of the stock market shows that improving sentiment and rising earnings forecasts are very unlikely to be permanent features across equity markets. This could mean that defensive stocks enjoy greater demand from investors in future.
In addition to a possible shift in sentiment towards defensive shares, BAT and Pennon could benefit from their improving outlooks.
Pennon recently sold its waste management business, Viridor, for £3.7 billion in cash. It is using part of this money to reduce debt, while it is considering potential investments for the remainder. It has around £2.7 billion to invest in potential projects that could catalyse its long-term performance. The firm is also making good progress under the new K7 regulatory period. According to its latest half-year results, 80% of its commitments under the new regulatory period are already on target.
BAT is also making progress in implementing its strategy. It is deleveraging its balance sheet, while seeking to shift resources towards next-generation products such as heated tobacco. It remains on track to generate £5 billion in annual revenue from new category products by 2025. This may help to align the business more closely with ongoing consumer trends. In the meantime, its tobacco pricing power is likely to provide it with investment capital for next-generation products.
As well as their defensive appeal, BAT and Pennon offer income investing prospects. BAT will seek to maintain a 65% dividend payout ratio, which could provide dividend growth alongside its yield of over 8%. Pennon’s dividend yield of 2.2% is low in comparison. However, the company plans to raise shareholder payouts by inflation plus 2% over the medium term. It may also experience a boost to its financial performance from a possible reinvestment of proceeds from the Viridor sale.
In the short run, investors may shun stocks with attractive income prospects and defensive credentials in favour of growth shares. However, over the long run, bull markets are ultimately unsustainable. With the economic outlook being very uncertain, defensive shares may currently be underrated.