It is said that Chairman Mao claimed communism to represent a state of "permanent revolution". Seen through the zealous eyes of an idealogue, that may have held some semblance of truth but, in reality, a state of permanent revolution is much more soundly represented by its antithesis – capitalism – the powerful and ever-present effects of competition, albeit within a stable political and economic framework, making it the greatest force for increasing productivity, and therefore profitability, known to man. Such is its power that no company – however large or financially stable – can insulate itself wholly or indefinitely from the ravages of competition or other adversity.
For evidence, look no further than the waning use of the term 'blue chip' when describing certain types of corporate stock. The term emerged in the early 20th century and is derived from the game of poker where the blue-coloured chips held the highest value. The Cambridge Dictionary defines the term thus: "A blue chip company or investment is one that can be trusted and is not likely to fail." One might be tempted to infer from this somewhat unequivocal definition that 'blue chip' equates infallibly with safety; in the financial field, however, few things are certain. In common with most investment vehicles, The City of London Investment Trust has spent the majority of 2020 confronting the uncertainties of the current economic climate whilst positioning itself appropriately for those that lie ahead.
For decades, markets favoured corporations which were already substantial, for the simple reason that access to capital was limited: money attracted more money. Now, however, capitalism has evolved whilst technological advancements threaten all businesses, irrespective of size, and the rise of venture capital and private equity means that entrepreneurs possessing nothing more than talent and ideas can raise billions in days. Indeed, it's arguably the very essence of a highly efficient market that it allows heroes to become zeros. Historically, blue-chip companies were also national champions: the Germans took pride in Volkswagen, and the Americans in General Motors, for example. The former saw its share price plummet over 30% in just three days as a result of its 2015 emissions scandal; the latter, once the bellwether of the US economy, suffered falling market share and margins for decades until, in 2009, it detailed plans to issue up to 60 billion new shares in a bid to pay off debt to the US government, bondholders and the United Auto Workers union, leaving its stock investors with just 1% of the equity in a restructured automaker. Pan American Airways, once the largest airline in the world, is now a distant memory; Xerox Corporation, which invented photocopying, has gone the same way; Eastman Kodak filed for Chapter 11 bankruptcy in 2012.
Of the 30 shares that constituted the original Dow Jones index, only one, General Electric, is still in existence. Moving closer to home, the travails that have beset a number of UK corporate leviathans – the likes of BP, RBS, Marks & Spencer and Thomas Cook – are well-documented. Whilst the concept of a blue chip stock may be fading rather than wholly extinct therefore, these experiences, coupled with the impact of the Covid-19 pandemic, do beg the question as to what now constitutes an effective defensive investment strategy in the current climate. What one is seeking is an approach to portfolio allocation designed to minimise the risk of losing principal, essentially by identifying companies whose revenues and earnings have the potential to hold up reasonably well during a recession.
Typically, the approach has been to focus on sectors which displayed defensive characteristics on the basis that, even in recessionary times, they are less vulnerable to the vagaries of consumer demand:
- consumer staples – eg food, beverages, and non-durable household products
- utilities – eg water, gas and electricity (and, increasingly, internet-related services)
- health and personal care – eg pharmaceuticals, medical services, and medical equipment manufacture.
More recently, however, there has been a discernible shift in investors' views as to what constitutes a genuinely defensive strategy. Take the food sector – long considered a classic defensive play – and one of its giants, Kraft Heinz, the fifth largest food and beverage business in the world. Created in 2015 when Heinz merged with Kraft, it has been challenged by web-based disruptors like Amazon, by evolving consumer tastes for healthier and more organic food, by market consolidation, and by accelerating competition from online delivery start-ups. In the face of these challenges, it cut costs too far, failing to invest sufficiently in marketing and innovation, and took on too much debt. It's been largely downhill since: between February 2017 and February 2019, its shares plunged more than 60%1, it took a $15.4 billion write-down on the value of some of its struggling brands2, and it cut its year-on-year dividend by 36%.3
The pandemic-affected world is changing therefore and it’s by no means certain that companies which have displayed strong defensive characteristics historically will all continue to do so. In a sustained downturn, those with strong earnings growth, a powerful market position and the ability to disrupt established industries through the power of innovation may also be considered sufficiently defensive – Google owner Alphabet and Microsoft, universally considered growth stocks, might be good examples therefore, given that information technology can now be considered to be a consumer staple. As ever, shrewd stockpicking will prove an important component of success.
A second and frequently adopted defensive strategy is to target stocks with healthy earnings, and thus a relatively attractive dividend yield and payout ratio, especially when set against the yield available from UK government gilts and US treasury bonds – the so-called 'risk-free rate'. Defensive stocks display the ability to provide reliable dividend income, irrespective of the performance of the economy. In turbulent times, with share prices under pressure, the dividend yield becomes sufficiently high that investors with excess liquidity enter the market en masse, buying up those shares and driving the price upwards – hence higher dividend-paying stocks typically suffer less damage in a market downturn. In strained economic times, the stability of profits, and the dividends they support, is vitally important.
Within the Janus Henderson investment trust stable, The City of London Investment Trust has demonstrated its resilience over many years of solid outperformance. It focuses predominantly on large cap companies with cash generative businesses able to grow their dividends with attractive yields, and so shareholder returns continue to be derived from a mixture of capital growth and income. With regard to its defensive stance, consumer staples currently represent almost a quarter of the trust's holdings by value; the top three holdings – British American Tobacco, Unilever and Diageo – are all consumer staples.4
City of London Investment Trust - Top 10 holdings
|British American Tobacco||4.5%|
|Reckitt Benckiser Group||2.5%|
|Royal Dutch Shell||2.4%|
Source: Janus Henderson, 11.11.20
The summer of 1966 was significant for English football fans as it was the first (and most recent) time England won the World Cup. It was also the start of City of London’s dividend growth track record which has now continued uninterrupted for 54 years – the longest record of any investment trust and, importantly, a period in which the UK experienced no fewer than 11 bear markets.
Over that time, an initial investment of £1,000 has yielded investors £41,000 in gross income, assuming that they had not reinvested that income, compared to just £29,000 paid out by the UK equity market, as measured by the FTSE All-Share Index over the same period.5
In addition to providing investors with a growing source of income, if investors had reinvested their dividends back into shares in the trust over the same period, an initial £1,000 investment would be worth almost £600,000 today. For comparison, an investment of £1,000 in the UK market, as measured by the DataStream UK Market Index (data for the FTSE All-Share Index total return only goes back to 1986) would be worth just £368,000.5
Needless to say, there are major uncertainties in the months which lie ahead – Covid-19 and a second wave, the long-term effect of the massive build-up of government debt, and Brexit being the most obvious – and so it's likely that City of London will have ample opportunity to display its defensive credentials yet again.
1Source: NASDAQ, 17.02.17 to 22.02.19
2Source: Reuters, 21.02.19
3Source: The Kraft Heinz Company, 2019 vs. 2018, http://ir.kraftheinzcompany.com/stock-information/dividend-history
4As at 30.09.20
5Janus Henderson/Refinitiv Datastream, 01.01.66 to 30.06.20