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Defensive Blue-Chip Stocks Are Set Up For A Hard Fall

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Includes: AMT, AVB, AWK, AWR, BKH, CHD, CWT, DEF, DTE, HSY, NEE, O, PG, PLD, SCHD, SPY, TLT, WEC, WELL, WMT, WTR
by: Cashflow Capitalist
Summary

A near-future recession is widely anticipated.

Investors have rationally responded to the threat of recession by buying defensive stocks.

The problem is that this rational response has been taken to an irrational extent.

High-quality names in REITs, water utilities, electric utilities, and consumer staples are very richly valued today — far beyond what future growth prospects justify.

Blue-chip defensive stocks are, unfortunately, set up for a hard fall from these levels.

Thesis

If the U.S. economy slumps into recession in the next, say, twelve months, it will have been highly and widely expected.

There has been chatter about recessions on and off on the CNBC and Bloomberg TV networks, when the market is falling and anchors pause from their regular bullishness to hear out the cases of David Rosenberg, Mike Wilson, or David Stockman. This past month, recession forewarnings appeared on the front pages of several major non-financial publications such as the Washington Post. Major news networks are discussing the potential of a recession to tank President Trump's reelection chances.

Everyone knows about this upcoming recession. Indeed, unless you've been living in a monastery up in the mountains, completely disconnected from the world, it would be hard to miss.

When everyone begins to expect the same outcome, markets begin to reflect that. Since the Christmas Eve selloff in December 2018, investors' ears have become well-attuned to the appearance of red flags like a global economic slowdown, a manufacturing recession, trillions of dollars (and counting) of negative interest-yielding bonds, and so on.

What has been the advice of so many pundits on financial media and wealth advisors (including myself) this year? Buy Treasuries and defensive stocks.

And investors apparently listened, based on the performance of these assets this year. Compare, for instance, the total return of defensive equity ETFs DEF (the Invesco Defensive Equity ETF) and VIG (the Vanguard Dividend Appreciation ETF) as well as the iShares Barclays 20+ Year Treasury Bond ETF (TLT) to the total return of the S&P 500 (SPY):

Chart Data by YCharts

Now, DEF and VIG do tend to perform about as well as or slightly better than the SPY over long periods of time, so their performance this year isn't that striking. But what about TLT? Over long periods of time, the SPY far outperforms long-term Treasury bonds, even with the steady fall of long-term rates over the decades. TLT's slight outperformance this year is telling.

Clearly, investors have flocked to safety, defensiveness, and yields this year.

But that's nothing. Let me show you some defensive stocks - typically those of the best companies in their respective industries - that are ludicrously valued in relation to future growth prospects.

My thesis in the present piece is that, as investors have clamored into the highest quality defensive names this year, those stocks have been driven up to unsustainably high prices that the reality of fundamentals will eventually drag back down to earth.

Source

Let's start with one of my personal favorite sectors: REITs.

Skyscraper-Valued REITs

Let's take a look at five well-known REITs that are leaders in their various sub-sectors: American Tower Corp. (AMT), Realty Income (O), Welltower Inc. (WELL), Prologis Inc. (PLD), and AvalonBay Communities Inc. (AVB).

Each of these five have higher forward P/E ratios right now than at any time in the last few years:

Chart Data by YCharts

Now, it would be reasonable to object to this metric, as it is less meaningful for REITs as for other asset types. For REITs, FFO (funds from operations) is the industry standard measurement of profitability rather than earnings, as it describes more accurately the actual profits. (Though FFO still needs to be adjusted individually to arrive at the best description of cash profits.)

But when we look at price to free cash flow (FCF), we find the same result - each is as high as it's been in the last three years.

Chart Data by YCharts

Considering that most investors buy REITs for the dividend, let's take a look at the movement of the dividend yields for these:

Chart Data by YCharts

The only REIT with a higher dividend yield today than five years ago is AMT, which had only just begun paying a dividend three years before that. The REIT, a global cell tower landlord surfing the highly profitable 5G wave and delivering double-digit growth, has grown its dividend at a breakneck pace of ~23% per year over the last five years. But naturally, the rate of dividend growth is slowing slightly - a little less than 20% in the last twelve months.

Don't get me wrong. This is incredible growth. But everyone seems to know about it, and that is reflected in the stock price. Assuming an average of 15% annual dividend growth over the next ten years (which would be phenomenal for a REIT, even one paying out less than half of FFO as AMT currently is), investors who buy at today's price can expect to enjoy a yield-on-cost in ten years of... 5.91%. That's it.

In normal times, you can find plenty of quality REITs with dividend yields of around 4.5%. At that current yield, assuming paltry annual dividend growth of 3%, you would still end up with a better 10-year yield-on-cost of 6.05%.

The situation is even worse for the others in the group. Analysts expect -6.05% annual growth for PLD over the next five years. Investors would be lucky to have a 4% yield-on-cost in ten years for that one. For O, analysts expect 6.4% annual growth over the next five years, which is only slightly lower than its 6.93% annual dividend growth over the last ten years. Assuming 6.4% dividend growth over the next ten years, buyers at the current price could enjoy a yield-on-cost in ten years' time of 6.6%. But dividend growth has slowed to around 3% in recent years as the company gets larger and appropriate deals become scarcer. Assuming 3% dividend growth from current prices, one would end up with a yield-on-cost in ten years of 4.77%.

The same could be said, more or less, for WELL and AVB. Growth estimates and likely average dividend growth going forward do not correlate well with current share prices. Investors will wise up to this eventually, especially if a recession spurs them to rethink their holdings.

Water Utilities Up In The Clouds

Let's take a look at four high-quality, well-run water utility stocks: American States Water Company (AWR), American Water Works (AWK), Aqua America (WTR), and California Water Service Group (CWT).

The forward P/E ratios for these are staggering:

Chart Data by YCharts

For utility stocks, P/E ratios are more reflective of true profitability than for REITs. With that said, it's astonishing to see these (admittedly well-run) utility stocks being valued by the market like high-growth tech stocks.

But are they high growth? No.

AWR has achieved annual earnings growth in the last five years of 3.05%, and analysts expect 6% growth over the next five. At a 6% average annual dividend growth rate, buying AWR today would result in a yield-on-cost in ten years of 2.33%.

AWK has achieved annual earnings growth in the last five years of 5.92%, and analysts expect 8.2% growth over the next five. At an 8.2% average annual dividend growth rate, buying AWK today would result in a yield-on-cost in ten years of 3.41%.

WTR has achieved annual earnings growth in the last five years of 2.19%, and analysts expect 6.4% growth over the next five. At a 6.4% average annual dividend growth rate, buying WTR today would result in a yield-on-cost in ten years of 3.85%.

CWT has achieved annual earnings growth in the last five years of 10.59%, and analysts expect 9.8% growth over the next five. At a 9.8% average annual dividend growth rate, buying CWT today would result in a yield-on-cost in ten years of 3.57%.

Who knew water could be so pricey?

High Voltage Electric Utilities

Let's look at four top notch, conservatively managed electric utilities: NextEra Energy Inc. (NEE), WEC Energy Group, Inc. (WEC), Black Hills Corporation (BKH), and DTE Energy Company (DTE).

Here, again, we find forward P/E ratios higher than they've been in recent history:

Chart Data by YCharts

These are not quite as high as the water utilities (perhaps investors think that households would sooner stop paying their light bill than their water bill?), but they are high relative to the electric utility sub-sector as well as their own valuation histories.

Each of these names is richly valued with respect to future growth prospects.

NEE has achieved annual earnings growth in the last five years of 9.75%, and analysts expect 7.99% growth over the next five. At a 7.99% average annual dividend growth rate, buying NEE today would result in a yield-on-cost in ten years of 4.81%.

(By the way, for those who insist that NEE's relatively high growth negates any valuation issues, consider the fact that insiders have overwhelmingly been net sellers and disposers of the stock over the last 3 months and 12 months. Also, on Wednesday of this week, management announced plans to sell "equity units" which "consist of a contract to purchase NEE shares in the future." In other words, they are selling equity now that gives them the ability to buy back shares in the future. What does that sound like? To me, it sounds like NEE management is short-selling its own stock!)

WEC has achieved annual earnings growth in the last five years of 8.29%, and analysts expect 6.12% growth over the next five. At a 6.12% average annual dividend growth rate, buying WEC today would result in a yield-on-cost in ten years of 4.38%.

BKH has achieved annual earnings growth in the last five years of 1.38%, and analysts expect 2.96% growth over the next five. At a 2.96% average annual dividend growth rate, buying BKH today would result in a yield-on-cost in ten years of 3.45%.

DTE has achieved annual earnings growth in the last five years of 8.13%, and analysts expect 4.45% growth over the next five. At a 4.45% average annual dividend growth rate, buying DTE today would result in a yield-on-cost in ten years of 4.42%.

Needless to say, now is not the ideal time to be buying these names.

Clean-Up On Aisle Nine

Consumer staples as a whole are not as egregiously priced, though they have done quite well this year. A handful of particularly defensive names, however, are reaching into bubble territory.

As a representative sample, consider Church & Dwight Co. (CHD), The Hershey Co. (HSY), Walmart (WMT), and Procter & Gamble (PG):

Chart Data by YCharts

Twenty-three to thirty times earnings for consumer staples? What mad world do we live in?

But wait! Maybe these are stealthy growth companies masquerading as consumer staples! Maybe the premium valuations are warranted!

... or maybe they're not.

CHD has achieved annual earnings growth in the last five years of 11.28% (not bad!), and analysts expect 8.16% growth over the next five. At an 8.16% average annual dividend growth rate, buying CHD today would result in a yield-on-cost in ten years of 2.48%.

HSY has achieved annual earnings growth in the last five years of 9.39%, and analysts expect 7.65% growth over the next five. At a 7.65% average annual dividend growth rate, buying HSY today would result in a yield-on-cost in ten years of 4.01%.

WMT has achieved annual earnings growth in the last five years of 0.53% (yikes), and analysts expect 3.69% growth over the next five. At a 3.69% average annual dividend growth rate, buying WMT today would result in a yield-on-cost in ten years of 2.63%.

PG has achieved annual earnings growth in the last five years of 2.7%, and analysts expect 7.3% growth over the next five. At a 7.3% average annual dividend growth rate, buying PG today would result in a yield-on-cost in ten years of 4.9%.

Conclusion

It's impossible to time exactly when the fall will come, but historically, when stocks are trading significantly above their average price-to-earnings valuations, future returns are poor.

It is understandable that investors would flock to defensive names with a probable recession on the horizon. But valuation always matters. Overpaying for any security, even a defensive one, sets one up for failure.

I would urge caution for blue-chip defensive stocks going forward. They appear set up for a hard fall when the bull run grinds to a halt.

Disclosure: I am/we are long O, WELL, WEC, PG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.