Investors usually consider Utilities, Consumer Staples, and Healthcare to be “defensive” sectors because these companies tend to outperform in the late stages of a mature business cycle. The companies tend to do better because their cash flow suffers less during an economic contraction. It is reasonable to assume that consumers may stop spending on leather bags and jewelry but the light-bill is usually a top-priority.
Historical performance shows that defensive stocks act the way we would expect on average; however, there are companies included in these categories that will likely suffer as much as any growth stock if the market starts to get bearish. At first glance, these ‘pseudo-defensive’ stocks look like their peers, but there are some tell-tale signs that they aren’t going to add diversification benefit to a portfolio during times of uncertainty.
This is an important concept for long-term portfolio managers to understand but it also may present opportunities for traders who expect these stocks to be among the first sold if sellers start to emerge. Traders tend to dump pseudo-defensive stocks like this in a volatile market because they represent low growth opportunities on the rebound and limited diversification benefit during the decline.
High Debt Levels
Over the last several years, debt has been easy and cheap. It has become more popular for defensive companies to use leverage to increase payments to shareholders, conduct buybacks, or acquire new assets. Defensive stocks are defensive because their cash flow is relatively secure compared to other companies. Excessive levels of long term debt can put that cash flow at risk because it increases the company’s sensitivity to changes in interest rates.
This particular issue can slip past many investors/analysts because defensive firms typically carry a much higher than average debt level compared to equity than the norm amongst the S&P 500. It’s also easy to ignore the risks of debt while a normally stodgy company is delivering growth-like returns during a bull market.
First Energy (FE) is a good example of the problem that can be created by leverage for a defensive firm. Since the crisis, FE has accumulated 38% more debt while revenue has been flat, net income contracted, and free cash flow evaporated. This utility provides services from Ohio to New Jersey and operates one of the largest distribution networks in the country. FE is regulated and does not seem likely to go out of business, but the weight of debt reduced its ability to defend against bad weather and a weak power market over the last two years.
In many ways, FE is similar to Exelon (EXC), which is another company that has been using debt to fund expansion and distributions to shareholders. Again, the issue isn’t that either company looks likely to go out of business. Excessive debt makes it more difficult for these firms to provide the kind of value defensive-investors are looking for because their cash flow is at risk. As you can see in the chart below, FE has been declining as investors worry about rising interest rates and a slow economy, which is just the opposite of what we would otherwise expect.
From a technical perspective, the stock is experiencing a bearish divergence between the price and the Moving Average Convergence/Divergence (MACD), which tells us a lot about investor momentum. The stock has already pulled back towards support and we expect a break of $31 to send it even lower. You don’t have to look much farther than the interest rate shock last May to see what a brief downturn in the market can do to FE.
The bottom line is that sometimes it takes a second look at a company to determine what kind of risk they really represent to a portfolio. An overleveraged defensive stock isn’t really defensive at all. Instead it can be a hidden land-mine in a portfolio that is likely to be dumped when the market turns lower. This may give shorts an opportunity to profit from a stock that is a lot more fragile than it looks on the surface.
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