Value is outperforming, and the US is underperforming. No, this isn’t a dividend letter from 2022. The trend that started last year, where investors refocused on valuations has continued. It has simply been overshadowed by the stellar performance of a handful of mega-cap US tech firms. Value is outperforming in all regions outside of the US. And in the dividend universe the US is actually the laggard. The reason behind this? Defensives.

Last year we have already seen companies that rely on cash flows far in the future being repriced lower. This year, also the defensive companies that actually have very stable near-term cash flows are under pressure and are being repriced lower. Looking at the performance per sector for the MSCI world, we find all the defensive sectors (health care, staples, utilities and real estate) at the bottom of the table. The bond proxies are getting competition from the things they were replacing, bonds. Higher interest rates have made bonds an attractive alternative again. And with the market rethinking the valuation of defensives, we are actually seeing opportunities opening up to add these high quality companies to our portfolio.

Chart 1: Defensive sectors underperforming in 2023

Total return in euros (Jan-Oct) per sector for the MSCI world

Source: Factset, October 2023

Because of that, for a long period we have been underinvested in defensives. They often used to only fit two of our three investment beliefs: strong cash flow generation and sound capital allocation, but their valuation was often excessive in our eyes. The long-duration trade, where defensives got increasingly more expensive as interest rates declined is now unwinding. With valuations now back at more reasonable levels, we are rethinking our defensives exposure as their risk-reward becomes much more attractive.

In many cases, the repricing lower is not necessarily an indication of improved valuation, but simply a reflection of a new economic reality. Circling back to our investment principles, this can be driven by bad capital allocation. In some defensive sectors, asset inflation has led to lower returns on capital. This problem was often solved by using cheap debt to boost returns. Which worked, until interest rates started to rise. When returns on an asset are low and income streams are fixed, a rising interest burden squeezes returns. Sometimes to the point where it becomes value destroying. Real estate is a good example of this, where leverage issues often need to be resolved first before it can become an interesting investment again..

Within the Consumer Staples sector there are many companies with pricing power and market-leading brands in attractive product categories. This leads to stable growth opportunities, attractive margins and solid cash flow generation. Rising bond yields and worries around the potential impact of GLP-1 weight loss drugs on consumer goods companies, has pressured valuations within the sector. That means we are finding new opportunities to add high-quality names to the portfolio that now offer an appealing risk-reward profile.

The underperformance of defensives this year is not a carte blanche to load up on them. As said, for some the repricing lower is a justified reflection of a new reality. What we are looking for are companies that offer an attractive risk-reward. And with defensives repricing lower we are now better able to add those high quality names to our portfolio which offer a high resilience in bleaker economic times, now at a more attractive price.