AFTER EUROPEAN CENTRAL Bank president Mario Draghi disappointed with less-than-concrete measures to save the eurozone, investors are once again left waiting and hoping for a solution to the European sovereign debt crisis. And that means markets are probably going to be left to range trade for quite a while longer.
Investors around the world continue to flee to the safety of income-yielding assets. According to EPFR Global, which provides fund flow information, flows into high yield bond funds exceeded US$2 billion ($2.5 billion) in the week ending July 25 – the sixth time in the 30 weeks year-to-date. Dividend equity funds absorbed a net US$858 million in a week when outflows from all equity funds exceeded US$10 billion.
Yet investors should be careful not to get carried away with defensive strategies or they might end up ignoring some good bargains and missing out on a market rebound when it comes eventually. In a recent report, Credit Suisse highlights that the cyclical-defensive valuation gap is approaching lows reached in the 2008 to 2009 crisis period.
On a price-to-book basis, stocks the tech, energy, materials, consumer cyclical and industrials sectors are on average valued at 1.68 times. In comparison, telcos, consumer staples and utilities have a price-to-book ratio of 2.28 times. That puts the valuation gap between cyclical and defensive stocks at 0.6 times: 82% of the valuation gap of 0.74 times seen at the last low point.
Credit Suisse suggests that investors try to pick out quality cyclicals, which it defines as companies with either a rising return on equity (ROEs) and/or companies that tend to see their ROEs trough at a high level. Her top picks for quality cyclical just now are Korea-listed Samsung Electronics Co, Kia Motors and Hyundai Motor, as well as Taiwan Semiconductor Manufacturing Co (TSMC).
Kia Motors’ ROE troughed at a negative 6% in 2006. While ROE has slowed this year, it is still a very high 26%, Credit Suisse says. The bank estimates ROE in 2013 to still be a high 23%. Meanwhile, Samsung Electronics troughed at 10% in 2008 and has been on a rising trend since then. Credit Suisse estimates ROE to be close to 21% this year and next.
In 2001, TSMC saw its ROE bottom out at 5.5% but since then the company’s ROE has risen steadily and stayed high. In 2008, its lowest point was 18.4%. “We believe this is a very high ROE given the depth of the global recession in 2008 and 2009,” says Credit Suisse. It estimates that TSMC will show an ROE of close to 25% this year. Finally, Hyundai Motor’s ROE bottomed out at about 5% in 2008 and has been rising ever since. While ROE has slowed this year, Credit Suisse analysts are looking for ROE of 21.5% this year.
And what are the overvalued defensive stocks that investors should stay away from? On a price-to-book and ROE valuation model, Credit Suisse recommends investors switch out of 12 stocks: Bangkok-listed convenience store operator CP ALL, Hong Kong-listed snack food maker Want Want China Holdings, India-listed consumer goods group ITC, Hong Kong-listed diaper company Hengan International Group Co, Taiwan-listed convenience store operator President Chain Store, Hong Kong-listed luxury goods maker Prada, Hong Kong-listed instant noodle maker Tingyi (Cayman Islands) Holding, Hong Kong-listed cosmetics retailer Sa Sa International Holdings, Thailand-listed supermarket operator Big C Supercenter, Thailand-listed telco Advanced Info Service, Malaysia-listed telco Maxis and Australia-listed pharmaceuticals company CSL.
While Credit Suisse acknowledges that these defensive names also have a growth element to them, it argues that investors are likely better off making a switch to cyclical stocks just now. “While the risk is that these stocks stay overvalued or get even more overvalued, we remind investors of the many growth stocks that have de-rated in recent years – Anta Sports Products, Luk Fook Holdings International, China Yurun Food Group, Li Ning Co and Belle International Holdings, just to name a few. We believe the risk reward continues to favour a switch from defensives (particularly, the 12 most overvalued ones) to quality cyclicals and cyclicals with a price-to-book close to the 2008-09 lows.”
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