Anchor Your Portfolio With Defensive Income Stocks!

The robust rally in the Hang Seng Index, which has climbed 29.3% since February 2016 (in HKD terms as of 7 March 2017), could well stay on course! As the stock market never moves up in a straight line, the effects of any one unexpected event or setback could result in a worse-than-expected pullback in the short-term. While it is not time to head for the exits, investors who may wish to protect their stock market winnings can introduce some dividend-generating resilience into their investment portfolios using defensive income stocks. In this article, we highlight two defensive income stocks that investors can consider, and illustrate the role of defensive income in fortifying portfolios.

Defensive Income: Portfolio Anchors For Stormy Days

Defensive income stocks refer to dividend-paying companies operating in industries that are largely insulated from the business cycle, and whose profits and share prices are less correlated to the overall strength of the economy. They are usually companies that produce or sell daily necessities, such as food, power and healthcare, all of which are items that consumers are unlikely to cut back on even when times are tough. As defensive income stocks tend to be less susceptible to market pullbacks, investors can count on them to provide stability to their investment portfolios in times of market volatility. Their regular income stream, in the form of dividends, is a further reason to hold them as part of a diversified portfolio. Over longer holding periods, defensive income stocks also provide potential for capital appreciation.

Investors can find on FSMOne a range of four thematic portfolios that are constructed using pre-defined filters to reflect a certain market trend or investment strategy. Investors who are looking to increase their exposure to defensive income stocks will be most interested in the Defensive Income portfolio that features up to ten high dividend-paying stocks whose share prices are less volatile than the broader Hang Seng Index i.e. stocks with a beta of less than one. Beta is a measure of a stock's volatility in relation to the overall market. A beta of less than one means a stock is less volatile than the market, while a beta of more than one means a stock is more volatile than the market. An above-average dividend yield relative to the Hang Seng Index is also built into the filter to further narrow down the investable universe, from which we cherry-picked two defensive income stocks that investors can consider.

1. Li Ka Shing's Global Infrastructure Powerhouse

Since its listing on the Hong Kong stock exchange in 1996, Cheung Kong Infrastructure (HKEX.1038) has grown into a global infrastructure powerhouse. Its portfolio of infrastructure investments spans eight countries, with a focus on regulated utilities, providing such services as electricity generation, natural gas distribution and water service provision. It has a stake in Power Assets (HKEX.6), a constituent of the Hang Seng Index that invests in power and utility-related assets. Cheung Kong Infrastructure (CKI) is also involved in the operation of toll roads and bridges, as well as the leasing of rolling stocks. As these utility and user-pay assets tend to generate stable and consistent cash flows, they have facilitated the continued growth dividend pay-outs of CKI over the past two decades (Chart 1). The company's five-year beta of 0.26 is also a reflection of its defensive attributes.

Chart 1: Continued Growth In Dividends Over Past Two Decades

At its last transacted price of HKD 62.65, CKI traded at a PE ratio of 15.3X that is below the industry average of 18.5X, based on 2017 estimated earnings (Table 1). Its balance sheet also remains robust, with total cash on hand at HKD 11.3 billion and a net debt-to-equity ratio of 5.8 (as of 1H 2016) that is well below that of its other peers, putting it on a firm footing to pursue expansion initiatives. With the management signalling its intent to continue its foray into different infrastructure assets across electricity, gas, water and transportation, investors can expect CKI to make further acquisitions, which could in turn boost earnings growth over the next few years. While CKI's recent attempt to acquire state-owned Ausgrid has been thwarted by the Australian government, it remains in the running to buy over Duet Group, a move that could potentially add to its suite of energy infrastructure assets, as well as Q-Park, one of Europe's largest parking lot operators.

Table 1: Valuations Of Hong Kong Utility Stocks

2. Finding Resilience In Fresh Water Distribution

Headquartered in Hong Kong, Guangdong Investment (HKEX.270) is a subsidiary of the state-owned Guangdong Holdings and is primarily engaged in the distribution of fresh water supplies, a 'boring' business that hardly gets investors' hearts pumping, but has good earnings visibility and resilience even in the face of market downturns. The company earns about two-thirds of its revenues from supplying fresh water to Hong Kong, as well as Shenzhen and Dongguan in mainland China. It operates the Dongshen Water Supply Project that supplies about 80% of Hong Kong's water needs, and from which Guangdong Investment will stand to receive a pre-determined amount of revenue from the Hong Kong government over 2015 – 2017 (Chart 2). The lump-sum payment amount for the next contract period over 2018 – 2020 will soon be re-negotiated, but the likelihood of a price reduction is low, given that the Hong Kong government has an incentive to maintain a stable water supply, with other cities like Shenzhen and Dongguan also competing with Hong Kong for fresh water supplies. On top of fresh water distribution, Guangdong Investment also owns other defensive infrastructure assets such as power plants and toll roads in mainland China.

Chart 2: Annual Revenues From Hong Kong Water Supply Arrangement

Guangdong Investment's five-year beta of 0.56 underscores its defensive characteristics. While the company has exposure to cyclical businesses, such as its property development, department store and hotel operations, they constitute only about 23.2% of total revenues. It is currently trading at a PE ratio of 13.7X based on 2017 estimated earnings that is slightly below the industry average of 14.0X (Table 2). It is worth noting that Guangdong Investment has a fairly strong track record of paying out growing dividends, supported by its strong cash flow generating prowess. The consensus is expecting the company's dividends to grow by 12.9% in 2017, which translates into a forecasted dividend yield of 4.09% that is above the Hang Seng Index average. Being one of the few companies in the industry to have a net cash position, it remains in a good position to fund its investments in other defensive assets without the use of debt financing.

Table 2: Valuations Of Hong Kong And Mainland China Water Suppliers

Defensive Income Stocks As Part Of Diversified Portfolio

Consider this simple example: if you had sunk all your savings into the Hong Kong equity market in April 2015, when it was trading at its highest level since 2007, on the belief the rally would continue, your paper losses would have amounted to -11.2% so far (as of 7 March 2017 in HKD terms, including dividends). In comparison, if you had invested 20% of your total assets into Cheung Kong Infrastructure (HKEX.1038), 20% in Guangdong Investments (HKEX.270), and the rest of the 60% into the Hang Seng Index, your losses would have been trimmed to a more modest -6.6%. While not ideal, having some defensive income stocks in the portfolio has certainly helped to cushion steep losses in this scenario. The hypothetical portfolio has also outperformed the Hang Seng Index year-to-date (Chart 3), proving that defensive income stocks have the potential to do well even during periods of market upswings.

Chart 3: Defensive Income Stocks Has Helped To Cushion Losses

Investors seeking to protect their portfolios during periods of high volatility can consider increasing their exposure to defensive income stocks. In addition to strong cash flows, these companies typically have stable and resilient businesses that can weather weakening economic conditions. Moreover, defensive income stocks pay dividends, which can have the effect of cushioning portfolio losses in the event of a market pullback. While investors can utilise our sample Defensive Income portfolio as a starting point to select defensive income stocks, they should also consider other such factors as firm profitability, financial strength and the sustainability of dividends.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.