We have a long-standing love affair with blue chip stocks that have defensible and predictable earnings. These stocks tend to be characterised by relatively low share price volatility and dependable cash flow generation – all the necessary ingredients that make them an ideal addition to any portfolio.
This is one reason why the share prices of the likes of biotherapeutics company CSL Limited (ASX: CSL), airport operator Sydney Airport Holdings Limited (ASX: SYD) and shopping centre operator Westfield Corp Ltd (ASX: WFD) trade at a significant premium to the market. After all, you have to cough up for quality.
If you had any doubt about the handsome returns you can make from paying a premium for such stocks, often affectionately referred to as “expensive defensives”, data from Goldman Sachs will make you a convert.
The broker said its strategy of buying and shorting 40 stocks on the ASX 200 (Index:^AXJO) (ASX:XJO) with the lowest and highest share price volatility has produced an average annual return of 15% a year since 1996. This means you could have generated this handsome return if you bought blue chips that displayed the lowest four-year share price volatility and shorted those with the highest volatility.
Shorting refers to selling stock you borrowed in the hope of buying it back at a lower price to pocket the difference.
This strategy has worked very well over the past 20 years but Goldman Sachs thinks the tide is turning and this strategy is unlikely to work going forward because it believes our “safest” blue chip stocks now hold as much risk as the most volatile stocks in the S&P/ASX 200!
It isn’t the high valuation of the low volatility blue chips that has prompted the warning – it’s the prospect of rising interest rates. You see, low interest rates have provided a very strong tailwind for the expensive defensives and the group is currently trading on a forward price-earnings multiple of 18.6 times, which is 20% ahead of their long-term average.
“At the same time, the beta (a measure of price volatility relative to the market) of the most volatile stocks in the index has dropped well below previous troughs,” said Goldman Sachs.
“For the ﬁrst time in our history of data, ‘low vol’ stocks have just as much ‘market risk’ as their ‘high vol’ peers.”
The broker thinks the market is underestimating the risk posed by rising global interest rates, which seems to have taken over from “growth” as the key systematic risk in the market.
I don’t necessarily agree with the view from an Australian perspective due to poor wage growth, structural issues in the retail sector and lacklustre corporate profit growth. But this is certainly a risk we cannot afford to ignore as experience has taught me that no one strategy can work all the time in any market.
Other expensive defensives that Goldman Sachs think are at risk include hospital operator Ramsay Health Care Limited (ASX: RHC), packaging company Amcor Limited (ASX: AMC), AusNet Services (ASX: AST), gas pipeline owner APA Group (ASX: APA) and Investa Office Fund (ASX: IOF).
However, this isn’t to say there are no other buying opportunities worth considering at this current point. Click below to get some great stock ideas from the experts at the Motley Fool.