The stock market is no longer obviously cheap. I know this because more investors have started to ask me about investing during a bull market, and where to look for defensive shares when nothing seems to be cheap. My response is that there is always something cheap; you just have to know where to look.
One way to whittle down the investment universe into digestible, bite-sized chunks is to separate it into indices. Since I’m a defensive value investor, I’m not interested in the FTSE Fledgling index, so here I’ll concentrate on the ‘big 3’: The FTSE 100, FTSE 250 and FTSE Small Cap indices (although only the biggest of the small caps are usually on my radar).
I’m looking for quality and growth from the underlying companies, and value for money combined with income from low share prices and high dividend yields.
Defensive shares in the FTSE Small Cap index
Out of the 260 or so companies in the small-cap index, there are only 56 that meet my cut-off criteria of having paid a dividend every year over the last decade.
The median results of these 56 dividend-paying small-cap companies are:
- PE – 21.2 (although I don’t pay too much attention to the standard PE ratio as it’s too volatile to be of much use)
- Dividend yield – 2.7%
- PE10 – 17.9 (share price relative to ten-year average earnings)
- Growth rate – 3.6% per year over ten years
- Growth quality – 66.7% (i.e. increased revenues, profits and/or dividends 67% of the time over the last decade)
What’s interesting about this small-cap group is that 20 out of the 56 companies have had negative growth over the past decade.
Perhaps companies that have been around for at least ten years and have yet to break out of the small-cap index are not the most successful in the world. It may be the case that defensive and successful companies get bigger and eventually grow out of this index, leaving behind a large proportion of companies headed downward rather than upward.
Defensive shares in the FTSE 250
Out of the 250 companies that make up this index, there are 106 that meet my reliable dividend payment criteria.
The median results of these 106 FTSE 250 companies are:
- PE – 19.2
- Dividend yield – 2.4%
- PE10 – 23.8
- Growth rate – 8.4%
- Growth quality – 75%
Two things are immediately apparent. The companies in this group have been more successful, on average, than their small-cap peers. The growth rate of these mid-cap companies is 8.4% compared to 3.6% for the small-caps, and growth quality is 75% compared to 67%.
Valuations are a bit of a mixed bag. The current average PE is slightly lower, but only just. The more stable measures of PE10 and the dividend yield both indicate that these FTSE 250 companies are more expensive than the small-cap companies, which is what I would expect given that the FTSE 250 companies have been growing faster.
Of the two groups, my preference would be to look at the faster-growing, better-quality mid-cap companies. That’s because while their growth rate is almost 5% a year better than the small caps, you only have to sacrifice 0.3% of the dividend yield to buy that additional growth (although, of course, future growth is going to be variable and not guaranteed).
Defensive shares in the FTSE 100
The large-cap index is, of course, the natural home for most defensive companies. Of the 100 companies in this index, 75 of them have paid a dividend in every year of the last decade.
The median results for these 75 FTSE 100 companies are:
- PE – 17.4
- Dividend yield – 2.9%
- PE10 – 21.7
- Growth rate – 10%
- Growth quality – 79.2%
Here it seems that the biggest companies have both the fastest growth and the best quality growth, which might be surprising given the cliché that “elephants don’t gallop”.
However, investors don’t seem to be convinced that these companies can keep growing, because their shares have the highest average dividend yield at 2.9%, the lowest PE and a PE10 value in between that of the two other groups.
Personally, I’m inclined to ignore those other investors and buy where others are selling. And so, with faster, more consistent growth, higher yields and lower valuations, the best place to look for defensive shares at the moment is probably (and somewhat unsurprisingly) the FTSE 100.
John
I don’t have such biases like you.
I don’t have a dividend bias and I am happy to let company reinvest if they can offer a high rate of return. I am also happier for companies to buy back their own shares than paying out dividends, as this is more tax efficient for HNW investors and you attract more of those and stock prices will go up.
I don’t have a bias where the company is quoted: UK, Europe, US, Japan or Australia. The best investments I did in the last 12 months was with European companies, because these are the cheapest.
Buying using price measures could be very damaging for portfolios. I work in the financial services industry, and I was seeing that insurer were not fit for purpose anymore after the Retail Distribution Review (RDR). I didn’t see George coming with his announcement on pension annuities which damaged businesses like Aviva, Prudential, L&G forever. I did not invest in such businesses before and I will not in the future.
They compete now for the last possible way to make a turn and a margin: the auto-enrolment. For the majority this is unprofitable, and may or not become profitable. The cost of AE funds were capped at 0.75% per annum, which was another blow to them.
I wish them luck, but I stay out. Dinosaurs can’t be saved.
Eugene,
I agree with your comments.Well said.
John,
You dont say wich companies fall into your 3 groups at all, but you just give percentages of your indices. The article just sounds as an advert to attract people.Have I missed something?
Hi Pulpos
Specific stock ideas wasn’t the point of the article. I was just pointing out the relative features and valuations of the three sub-indices of the FTSE All-Share, which I think is helpful if people are looking for relatively defensive but growing companies at reasonable valuations. From my analysis the FTSE 100 was the best index to start such a search.