Being defensive against the Interest Rate Cycle

The increase in South Africa's consumer price index (CPI), which is used by the South African Reserve Bank (SARB) for its inflation target, has slipped to 6.7% year-on-year (y/y) in July from 6.9% y/y in June, Statistics South Africa (Stats SA) said during the week.

According to a survey of leading economists, consumer inflation was expected to have receded to 6.6% y/y in July with forecasts ranging from 6.3% to 6.8%. The CPI figure was slightly disappointing as it shows that inflation is still sticky, and that it is likely to go up again at the end of the year. The Reserve Bank has cut the repo rate by 500 basis points and the consensus is that we must be close to the bottom of the interest rate cycle. Some people have already positioned their investment portfolios ahead of a rise in interest rates possibly next year. Tough economic and market conditions provide operational and financial adversity for most companies. Some businesses, however, do not feel the same pinch and this makes them good defensive plays in bad market conditions. A situation where rising interest rates are affecting the financial situation of customers, will in turn impact the company. As customers reduce their spending, the number of orders decreases; customers may not pay their bills, thus reducing the working capital of the companies that they owe to and leave the business with lots of bad debts. Risk is a critical variable for investors when deciding where to park their money. Companies that have a business model insulated from economic downturns are viewed as attractive and safe investment opportunities. A cash cow can continue to produce cash flow streams despite lagging economic activity.

So, what makes a defensive company? A company that sells essentials is considered defensive. Food retailers are considered defensive shares because people still need to eat. Companies that provide non-essential services are typically the first to receive tough operational and financial blows in tough times. Secondly, a company that serves a customer base that is insulated from economic meltdown, for the most part have stable revenue. Companies such as British American Tobacco and SAB Miller are considered defensive. There are limited or no substitute product for their business models and it will take more than rising interest rates to force people to give up smoking and drinking. Thirdly, a company that provides proprietary, niche products within the marketplace is considered defensive.

Pharmaceuticals and healthcare companies with drug patents are classic examples of companies with relatively inelastic demand for their products. Unfortunately, all the shares mentioned here are regarded as fairly valued from a fundamental valuation point of view, while the technical charts show that they are all trading near their historical highs. The market has already discounted the rise in interest rates and bought into these defensive type companies, creating demand and pushing their valuations and share prices higher.
There is still value in the construction sector with a company like Protech, for example. The share seems inexpensive trading on a rolling P/E ratio of less than 3.5 times with a reasonable return on equity (ROE). We are, however, concerned about the group's high level of financial gearing, especially should the construction boom not be sustainable for the medium term. But should the government spend on infrastructure as they said they will, the construction sector should perform well. Accordingly, we would only recommend the share as a buy to speculative investors at this stage. The chart of Protech shows that the share price is trading above its moving averages and the trend remains bullish. The share is overbought with some technical indicators suggesting a change in trend soon. Rather wait for the price to fall to about the 80c support level before buying in again.