The turbulence in the markets is a reminder of the benefits of defensive investing. Theories abound on the reasons for the sell-off – a reaction to China’s stockmarket slump, or a tremor set off by fears for the US economy. Whatever the cause, I don’t believe it’s crunch time. Things may be moving in an unsustainable direction and, sooner or later, something will have to give – I just don’t think that time is now. If problems in the US property and sub-prime mortgage lending markets have a negative impact on the consumer, then that will flow through to inflation, the authorities will cut interest rates, and we’ll go through another cycle, the severity of which will be determined by the Federal Reserve. I could be wrong: the US may be heading for a rather nasty slump. In that case, investors will want to be positioned as defensively as possible.
Defensive stocks: Cadbury Schweppes
Traditionally, this has meant investing in firms such as food producers and utilities, whose products people will still buy even in dire economic straits. One such stock, Cadbury Schweppes (CBRY), was recently identified by my investment model as offering value. It doesn’t exactly produce dietary staples, but I’m hedging my bets: I don’t think the global economy is going down the tubes, but it may, so I want both downside protection and upside exposure. The fact that many of its products date from the 19th century attests to Cadbury’s defensive qualities; and the fact that it’s in the FTSE 100 shows it’s got the ability to grow.
Last month, Cadbury announced its full-year results to the end of 2006. They were widely considered uninspiring, with underlying pre-tax profits towards the bottom of City estimates. Inevitably, the focus was on the recent salmonella scare at the firm, which cost £30m, and its accounting anomalies in Nigeria. But beneath the surface, things weren’t quite so bad. Underlying earnings per share (EPS) were down, but excluding disposals, diluted underlying EPS from continuing operations were up 5.8%. Revenues in emerging markets (especially Africa, Asia, Latin America and Asia Pacific) were up 10%, and there were notable successes in the group’s mature markets too. In America, Cadbury’s share of the chewing-gum market rose by 300 basis points (the market itself grew by 8%) after the introduction of the firm’s long-lasting Stride brand in June to complement its Trident brand. Like-for-like revenues at its beverage unit increased 4%, despite a continued decline in the overall US carbonated drinks market. Meanwhile, the reorganisation of the group to focus on key markets, such as the integration of US bottling operations into a single Cadbury Schweppes Bottling Group, is beginning to pay dividends.
Clearly, Cadbury isn’t the next Google. But neither is it a sleepy relic of the past. There have been significant changes in the group over the past 25 years, such as its acquisition in 1995 of Dr Pepper/Seven Up, of Snapple in 2000 and of the Adams gum and confectionery business in 2003. Its share of the global confectionery market has grown from 5.3% in 2001 to 10% in 2005, and it ranks first or second in more confectionery markets in the world than any other company. The onus is now on management to deliver on its objective to ‘generate faster growth at higher margins’. But the City seems prepared to give Cadbury the benefit of the doubt. After good growth until 2002, underlying EPS stalled in the following three years. Now, however, analysts expect the growth recorded in the last 12 months to continue, with compound growth of 7% over the next two (and possibly five) years, putting the company on a multiple of just under 15 times forecasts for 2008. As most of the negative aspects in last year’s results were one-offs (eg, the benign US cough and cold season) and most of the positive aspects were more enduring, this seems achievable.
My model suggests that Cadbury is a sell at 756p and a buy at 550p – a level it fell through last week. As such, and because it also fits my strategic requirements, I’m happy to load up with a full weighting of Cadbury’s shares at the current price. I’ll probably begin to lighten that holding if the price exceeds 687p.
Defensive stocks: British American Tobacco
British American Tobacco (BATS), which I have previously tipped as a long-term buy at £14.91, has also been in the news. Results for the full-year to the end of 2006 beat City hopes, with diluted, adjusted EPS coming in at 98.12p, compared to a consensus of around 96.5p. BAT also announced a higher dividend payout ratio and an increased share buyback programme. More importantly, management reiterated its target of achieving future earnings growth in the high-single digits, suggesting that last year’s results weren’t just a flash in the pan.
Unsurprisingly, consensus forecasts have risen by around 1.7% for 2007 and 3.8% for 2008, which means my buy and sell limits for the stock have also changed. According to my model, the group is now a buy up to £16.28, while the sell limit has risen to £20.06. And just like Cadbury, it is unapologetically defensive. In fact, smokers must be among the most loyal customers in the world when the economic going gets tough. So here, too, is a company combining both value and strategic considerations. In a world of pretty efficient capital markets, that’s a rarity.
Charlie Gibson is an analyst and a private investor