Should you invest in big banking stocks or big pharmaceutical stocks right now? Both seem to be presenting an opportunity, but they are very different beasts.
Big pharmaceuticals such as GlaxoSmithKline, AstraZeneca and Shire earn the label ‘defensive’ because their underlying businesses tend to be good at generating incoming cash flow whatever the general economic weather. Selling medicines is a classic consumer goods set-up. Customers return time and again for their drugs, rarely missing a purchase just because economic times might be tough, which is great for investor dividends.
Big banking firms such as HSBC Holdings, Lloyds Banking Group and Barclays fall into the category of ‘cyclicals’ because their underlying businesses tend to thrive or shrivel depending on the health of wider economic cycles. Instead of the constant cash flow we see with defensives, cyclicals often suffer from plunging cash flows and falling share prices when economic times are hard, which is bad for investor dividends.
An emerging opportunity and a constant threat
Defensives are becoming cheaper because their share prices have been falling for the past year or so, mostly because valuations had risen too high. These also tend to fluctuate in a cycle of their own. When economic times are uncertain — such as over the past 10 years since the credit crunch — investors find the stability of defensives attractive and they buy their shares, driving share prices up. On top of that, interest rates have been low for so long that we’ve seen the so-called bond-proxy trade go something like this: “I can’t get a decent rate of interest on bonds or from bank accounts but look at those juicy dividend yields from defensive shares over there!”
Valuations of defensive firms appear to be cycling down right now. I think we’re seeing an investor rotation out of pricey defensives, such as big pharmaceutical stocks, and into cheap-looking cyclicals, such as big banking stocks. The general economic outlook is quite good, and the valuations of cyclical firms have looked low for some time. But I think there is a good reason for the market assigning a low valuation to the big banks and other cyclical firms. The market knows their profits tend to cycle up and down, and profits have been high for the banks and other cyclicals for some time. So, I think the market is keeping a lid on big bank valuations right now in anticipation of profits cycling down again at some point.
Yet economies are doing well and interest rates are on the rise. One argument goes that banks thrive in a higher-interest-rate environment. Maybe so, but I’m not expecting interest rates to shoot the lights out in the current macro-cycle, and I’m not expecting the market to raise the valuations of banks to growth-style ratings. I am, however, expecting a cyclical plunge in banks share prices, profits and dividends at some point. Such an event may be years away, but it’s still a threat. To me, the compelling retirement investing opportunity hidden in the banks-versus-pharma stocks debate is with the pharmas, and I’m ready to pounce.