In my last blog post, I took a brief look at the market’s defensive sectors and how they might be affected by a bond market crash.
Specifically, I looked at which sectors were most at risk from a valuation point of view. The basic idea is that as bond market’s fall their yields will rise, and as a consequence equity dividend yields will/could/should rise in response.
Therefore, the defensive sectors with the lowest dividend yields (and highest valuations) could be most at risk.
But dividend yields and share price valuations are not the only things that are likely to be affected by a bond market sell-off.
Heavily indebted companies could be at risk from rising bond yields
A falling bond market will see bond yields and other debt yields increase, which means companies will have to pay more to borrow money. This will obviously impact companies that have a lot of debt the most.
So another way of looking at which sectors are most at risk from a bond market crash is to look at the average levels of debt in each sector. If a sector has a lot of companies with higher levels of debt then that sector could be more at risk.
Capital-intensive companies could be at risk from inflation
One reason for rising bond yields is rising inflation. This can be a problem for companies that have capital-intensive businesses because they have to continually invest in new buildings, equipment and other expensive items which the company depends upon.
When inflation is high the cost of these capital goods typically increases every year. As a result, a capital-intensive company has to be able to find more and more money to upgrade and replace older tools, infrastructure and so on.
This isn’t necessarily a problem if the company can raise the price of its own products. If it can do that it can generate more profits which can be used to fund the spiralling cost of its capital investments.
However, if the company cannot raise prices, perhaps because it sells a commodity product where price competition is fierce, then it may struggle to afford the latest machines and other equipment it needs to compete effectively.
Combining the valuation risk, debt risk and inflation risk of each sector
In the first part of this two-part post, I looked at the defensive sectors from a valuation risk point of view by comparing the average dividend yield of each sector.
To compare each sector in terms of debt, I’ll use their average Debt Ratios, which is a company’s total borrowings divided by its 5-year average post-tax profits. A Debt Ratio of more than 5 is high.
To compare sectors in terms of capital intensity, I’ll look at each sector’s average Capex Ratio, which is the ratio between a company’s earnings and its capex over a 10-year period. Anything over 100% is high.
To compare them in terms of their ability to raise prices, I’ll look at each sector’s average net ROCE (post-tax return on capital employed over a 10-year period, or return on equity for banks and insurance companies). Anything below 10% is low.
So now we have some measures for valuation risk (dividend yield), debt risk (Debt Ratio) and inflation risk (Capex Ratio and Net ROCE), let’s have a look at how all the defensive sectors stack up.
The table above shows all the defensive sectors in order of their combined valuation risk and operation risk. They are in order from the highest risk to the lowest risk (at least according to this approach).
(I’ll put a note at the bottom explaining how the ordering of the sectors works, to avoid boring anyone who doesn’t care).
I’ve also colour coded the table showing the best (green) and worst (red) for each risk factor.
One interesting point is that the operational risks (Debt, ROCE, Capex) tend to be inverse to the valuation risk. In other words, weak companies with lots of debt, low returns and high capex requirements, generally trade on low valuations, which is what I’d expect from a reasonably efficient market.
On the other hand, good companies with little debt, high returns and low capex requirements tend to trade on higher valuations because these are generally high growth companies.
So while Mr Market may not be omnipotent, he isn’t completely stupid either.
Utilities most at risk from a bond market sell-off
Unlike my first article, which showed utilities to be least at risk from a valuation point of view (because of their high yields), they are the most at risk sector using this multi-risk approach.
The key difference in this analysis is their large operation risks, which both explain and largely negate their high dividend yields.
Both the Mobile Telecomms and the Gas, Water & Multiutilities (GWM) sectors have lots of debt (Debt Ratios above 5), produce weak returns on capital employed (ROCE below 10%) and have to invest more into capital assets than they make in profit (Capex Ratio above 100%).
The glaring red boxes of the GWM sector are potentially a big concern as these companies have benefitted massively from super-cheap borrowing costs over the last decade or so.
A reversal of that cheap debt trend could be a major problem for them.
Food producers and retailers also at risk
Food producers and retailers are at risk for different reasons. Food producers appear to have reasonable businesses overall, with reasonable debts (Debt Ratio of 2.8), weak profitability (ROCE 8.9%) and somewhat high but not excessive capex (86.7%).
They are, however, very expensive, with an average yield of just 2.4%. A bond market sell-off driven by inflation could affect their businesses as they have to spend a lot on capex. If that held back their growth levels they may not be able to justify such lofty valuations.
Food retailers, on the other hand, are at risk for the same reasons as the utilities: somewhat high debts (Debt Ratio of 4), low returns on capital (ROCE of 9.7%) and high requirements for new capital investment (Capex Ratio of 152.8%).
Given that this sector includes Tesco, Morrisons and Sainsburys, which are already struggling, a bear market in bonds – along with higher inflation and higher debt costs – would probably not be welcome at all.
Non-life insurance and Tobacco a potential safe haven
Insurance and tobacco could be a good place to hide in a bond bear market.
General insurers have, on average, very little interest-bearing debt, are healthily profitable and do not require massive capital investments. Their operations are not particularly at risk from a bond market sell-off, as long as they don’t have too much of their insurance “float” invested in bonds.
Their valuations, on average, also don’t appear to be at risk, as the sector’s average yield of 3.5% is about in line with the wider market.
Their operations are not particularly at risk from a bond market sell-off, and their valuations, on average, don’t appear to be at risk as the sector’s average yield of 3.5% is about in line with the wider market.
Tobacco could be another option. The sector has relatively high debts, but good profitability and little need for capital investment. Valuations are very low given the profitability and growth records of the companies, so valuation risk is probably not significant either.
Personal Goods and bio/pharma companies may be a good bet, if you can handle the valuation risk
The other traditional defensive sectors of Personal Goods and Pharmaceuticals also appear to be low risk from an operational point of view.
Each sector has low debts, high profitability and little need for capex. The risk for these sectors could well be the valuation risk I highlighted in the previous article. However, with such apparently good companies, those higher valuations may be justified.
Still, I would say these two sectors do carry a reasonable degree of short-term valuation risk, even if in the long-term they turn out to be solid investments.
Putting my money where my mouth is
Personally I am invested in all the defensive sectors, apart from Health Care Equipment & Services, Beverages and Personal Goods. Of course, I think the stocks I hold have less operational risk and less valuation risk than the average company in each sector.
But just in case I’m wrong, I’m spreading my bets far and wide.
Note on ranking the sectors by debt, ROCE, capex and yield –The first step is to sort the sectors by each factor in turn and then assign a “score” or “rank” depending on where a sector comes. So for example I sorted them by Debt Ratio (ascending order) and gave the sector with the lowest Debt Ratio a rank of 1 and the highest a rank of 13 (as there are 13 sectors). Then I did the same using ROCE and so on. The next step is to add together the individual ranks for debt, ROCE, capex and yield, into a single “total” rank, and then finally sort the sectors by their total rank.
Thanks John. Really enjoy your articles.
Just to mention on the utilities side, the UK regulated utilities are somewhat protected by their tendency towards issuing long-dated, fixed rate bonds (though they’ll swap a portion to suit their asset-liability planning) – short term rates movements don’t flow through fully to the bottom line. Also the 5-year regulatory price reviews do take into account cost of funding. Finally, as natural sellers of inflation, they can often find buyers who will pay up in terms of spread to buy inflation-linked exposure.
What do you think about property cos/REITs? These really are a play on cost of funding vs rental yields, but without as much natural appeal to bond investors as the utilities.
John Kingham says
Thanks Monty. Excellent points on the utilities. I did write about their ability to raise prices thanks to regulation, but edited it out as the article was going on forever. Thanks for highlighting it here.
I would still say their risk is on the debt affordability side of things. If you look at Pennon for example, which owns South West Water, it has massive amounts of debt, which it can just carry because of super-low interest rates.
I don’t think regulators would necessarily get away with pushing up prices for consumers just to pay for all that debt. An equally likely scenario, perhaps, is an equity raise.
But of course that’s pure speculation. Only time will tell although I certainly won’t be investing in any of those companies.
As for property-related investments, I don’t have much of an opinion as I don’t invest in property in any way, shape or form. I know that institutional investors have been getting more into property because of the lack of yield elsewhere, but really I don’t know much.
All I do know is that the UK residential market is overvalued, and stupendously so in London.
I will start by saying “there is still life in the old dog.” I was told so many times that Diageo is an expensive company, that I forgot to count.
However, there are some brazilian people who believe the company is cheap and they think they can buy it by employing high leverage (Don’t worry, I am not going to buy their junk bonds!). Shares went up yesterday 7%, but I believe based on Heinz experience they will need to offer at least 2,300 per share (if not more) if they intend to take it privately.
Good luck to them! Probably these people are not afraid of a “bond sell-off”. They may have not read about it in the press.
The problem with utilities is that there is no inflation in their prices. I was reading today about Drax, who owns a coal power generator in the UK, they were complaing about the wholesale price of electricty which went down influenced by the oil price, however the reduction of the price of coal did not match the reduction of the other commodities (oil and electricity). It is also the influence of these new wind farms and green energy stuff, which reduces the energy price. There is also the inflation kick which is missing.
I do own some green and renewable stuff through John Laing Environmental Assets investment trust, but I learned these investments are not that great either, although this investment trust is rather good at buying second hand wind and solar farms.
The main issue you face here is the high depreciation rate of the assets. To replace a solar panel with a new one, you pay now 35% of the amount you paid in 2009. So from the valuation point of the actives a solar farm is worth 35-40% of the value of the initial investments.
But the main issue are the initial business plans. It seems that the panels do not last for as long it was planned and the average production is a lot less than expected. Although the cost of a new panel is smaler now, the cost of finding the faulty ones and replace them is a lot higher than the panel itself. On top of that is the inflation kick, which is missing.
Yes, capital intensity – I don’t like it. Added to that products and services non-differentiable – gas, electricity, water etc. BT is the only utility stock I own, at least there is some differentiation going on. Up for Champions League next season? Only on BTSports!!
John Kingham says
Hi Eugen, I don’t watch football so fortunately I can skip all the expensive TV channels!
As for Diageo, I think it’s in pretty good shape. The valuation isn’t excessive (yield about 3%), growth is okay (8%, although revenue growth is pretty flat), post-tax ROCE is about 13% averaged over a decade. Debts are quite high, but not “too high” according to my rules (Debt ratio is 4.3, while I’ll allow 5).
So without having looked at it in detail I’d say it looks promising and those Brazilians seem to agree.
I really enjoy your blog and think you’re spot on about a lot of things – keep up the good work!
I am little skeptical about your debt ratio, however. In finance we typically use ND / EBITDA. Taking debt over earnings has a few issues:
– You are “punishing” the company twice for having leverage: once in the numerator and once in the denominator (as interest has already been removed from earnings)
– You are ignoring the various tax regimes. A company may have huge EBITDA / EBIT margins but a harsh tax regime, showing very little earnings. They may be perfectly able to service their debt, however.
– You are including the non-cash items of depreciation and amortisation in the calculation (not as much as an issue)
I guess as an equity investor who at the end of the day cares about earnings, these aren’t massive sins…but should still be taken into consideration. Especially if we are to take the Buffett / Graham approach of owning the whole business. Also, I generally dislike earnings / EPS as they are so easily manipulated and don’t have much bearing on the ability to pay a dividend…CASH is king!
John Kingham says
Hi John, I guess I would agree with each of your points.
I am punishing the company twice by including interest in the earnings figure, but that is by design as I want companies that pay higher interest rates to look less attractive.
I do include tax, but again tax has to be paid and higher tax rates means less cash for reinvestment etc.
I do include amortisation and depreciation, which I think is reasonable (at least the depreciation part) as depreciation effectively smooths out the cost of an intermittent capital expense, so it’s still an expense and will still impact cash at some point.
You’re right to point out these oddities (thanks), but they are by design. If the Debt Ratio turns out to have problems because of its treatment of interest, tax or depreciation I’ll fix them as they occur, but only as part of an “empirical” cycle of designing a metric and then testing it in the real world over many investments.
So far there have already been a couple of major tweaks to the way the Debt Ratio works, both of which made it more cautious than it was before as it let in companies that subsequently had debt-related problems. The current version seems to be working better, but if it requires further tweaks then you’ll definitely read about it on the blog.
And yes, I agree that earnings can be easily manipulated, which is why I take a broader view of success and look at sales, earnings, dividends, return on capital among other things. However, investors who only look at earnings and the PE ratio can definitely run into problems and they would do well to develop a more rounded view, in my opinion.