Executive summary

  • Defensives are significantly out of favour – we see a multi-year buying opportunity
  • The cyclical rally has run to a stage where valuations are hard to justify
  • The most loved stocks remain ‘TMT bubble’ expensive compared to other stocks in their own sectors
  • The outlook for dividends is improving and the level of dividends is highly compelling versus other asset classes


We would argue that there are two extreme divergences within market indices that investors should be wary of unwinding as the world normalises.

First, the degree of stimulus from governments and central banks has produced a dramatic cyclical rally, leaving cyclicals trading at multi-decade highs relative to defensives. We are sceptical that stimulus will lead to the type of sustained, healthy, real GDP growth that these sectors seem to be anticipating. Instead, we think this will lead to higher near-term nominal growth that favours equities relative to bonds – many cyclicals have already dramatically front-run rising bond yields. In our view, the ’sell defensives on rising bond yields’ argument has already played out and in fact gone too far.

Second, the most loved stocks remain very expensive relative to their own sectors. The Fed capitulation on quantitative tightening in late 2018 produced a powerful growth rally in 2019 that the pandemic amplified into full-on growth mania towards the end of 2020. The divergence of stock valuations within sectors remains at TMT bubble levels of dispersion. We expect this to normalise as economies continue to recover and broaden out.

Defensives offer a multi-year buying opportunity

The conventional wisdom of selling defensives as bond yields rise has produced an opportunity where, we believe, defensive sectors are cheap in absolute terms in a world where otherwise most financial assets are very expensive. The current situation, in which defensives yield much more than cyclicals, is highly unusual as you normally have to reach for yield in markets. This is because central bank stimulus created vast of amounts of liquidity that has made the main risk in markets being missing out on rallies rather than risks related to the fundamentals of companies. Fundamental risks like defaults remain suppressed by authority action, for now at least.

The opportunity cost for not taking part in these rallies has become extremely painful in performance terms. The unique nature of lockdown-driven recessions has also scrambled the patterns that are typical of more conventional recessions (this time, goods have held up far better than services and benefitted from some of their displaced share of wallet). In addition, many defensive sectors have not benefitted from falling bond yields as they prompted markets to chase scarce growth stocks rather than buy defensives. We see many parallels to early summer 2018 when we felt defensives were unusually compelling.

We expect the time horizon of markets to normalise at some point. As a result, we should see the underlying defensive compounding power come back into favour.

The valuation of our defensive stocks makes no sense relative to other asset classes. At one point in February, our Fund’s dividend yield net of taxes was in line with US high yield credit. There is no macro scenario in which this makes sense. The valuation of our defensive blue chips makes no sense in the context of bonds yielding almost nothing and growth stocks on 30x P/E or more. Many of our defensive stocks, until they rallied in mid-March, yielded in line with US high yield (and can themselves raise money in credit markets at near zero) – these include staples like Unilever and Danone, pharma stocks like Sanofi and Novartis etc. We expect the time horizon of markets to normalise at some point. As a result, we should see the underlying defensive compounding power come back into favour.

The extreme valuation opportunities in some defensives are attracting activist and private market attention. We have an unusual level of stocks that have become ‘special situations, showing others agree at the undervaluation. Several of our holdings are subject to activist investor approaches pushing for change (including Danone and Sampo) or bid speculation around stakes or the whole company (including KPN and Naturgy). This is unusual given the dull nature of the cohort of defensive stocks we like. The very wide discount of some public-listed equities is starting to be addressed.

Defensive stocks: resilient and cheap

Defensive Stocks  Resilient And Cheap

Source: Redburn Ideas, March 2021.

Our defensive stocks versus other asset classes

Source: Polar Capital, Bloomberg, March 2021.

Cyclicals’ valuations look stretched

The unprecedented authority response to the pandemic has produced an incredible cyclical rally. Data from strategists at Bank of America show cyclicals have outperformed 55% since the trough. This is the sharpest rally in 20 years and leaves them trading at multi-decade relative highs (both price relative to defensives and on a Shiller-relative P/E basis). It is usually very hard to meet the kind of expectations that are now priced into many cyclicals (see the two charts below). We see cyclicals as having more than front-run the bond yield pricing of recovery.

Our strategy is always underweight cyclicals, given defensive dividends are so much more reliable (as they proved to be in 2020). It strikes us as odd that this structural underweight in cyclicals would not stop our strategy outperforming markets 2011-18 but would struggle so much during a pandemic. Historically our best relative performance has come when the macro consensus was too bullish – 2011 and 2018 – as it is now, in our view.

Cyclicals at long-term highs versus defensives

Cyclicals At Long Term Highs Versus Defensives

Source: JP Morgan, March 2021.

Cyclical outperformance/value flat is unusual

Cyclical Outperformancevalue Flat Is Unusual

Source: JP Morgan, March 2021.

Loved cohort of stocks still ‘TMT bubble’ expensive

After the Fed capitulation on quantitative tightening in late 2018, there has been a well-documented outperformance of growth styles over value. The pandemic acted as an accelerant by producing dramatic plunges in bond yields and a near-term environment of lockdowns that favoured already loved sectors such as technology. We typically do not own deep value or expensive growth; historically, you could do well in the areas between these two parts of the market. However, post-2018 dramatic underperformance has spread beyond deep value to almost anything not in the loved growth cohort.

We struggle to have conviction in how much more expensive technology should be than banks – it feels like it should be a lot – but for us, the clearest sign of a bubble is the re-rating of loved stocks relative to stocks within their own sector that are by definition doing vaguely similar things (see the chart below). This has hurt our style as we tend to pick good companies that are out of favour. The past two years to mid-March has primarily been about the most loved stocks consistently re-rating away from the rest.

Valuation dispersion blown out within sectors

Valuation Dispersion Blown Out Within Sectors

Source: Kepler Cheuvreux, Datastream, March 2021. Note: For each sector of the index we Kepler calculate the standard deviation of its constituents' P/E ratios (12-months forward), to measure valuation dispersion within the sector. Kepler exclude values above 50x. Kepler then calculate the average of these measures across sectors.

Dividend guidance: proven resilience then returning to attractive growth

The outlook for dividends has improved after the carnage of 2020. We see 2020 as the ultimate dividend stress test, with dividends being cut for a variety of reasons. Some of these dividends were simply unsustainable going into the pandemic and would have been cut regardless. Others were, unfortunately, existentially hit by the unique situation of lockdowns that destroyed their capital structures. However, many other stocks chose not to pay dividends.

Our initial guidance for the Fund was of dividends paid in 2020 being down 15% on 2019. This was materially more resilient than the index which we estimate delivered dividends down roughly one third. For 2021, we presented a central dividend scenario of roughly flat year on year before the Fund resumed its historical mid-single digit dividend growth from 2022 (see the chart below). We remain confident with that guidance. This is because the pandemic continues to prove more problematic in Europe than in our previous central dividend 2021 scenario, but this is offset by an improvement in the broader dividend-paying environment (payouts are becoming less of a taboo again and regulators seem to accept some of their dividend bans were unacceptable). The medium-term dividend growth prospects are solidly underpinned by the fact that none of our portfolio holdings issued capital last year so the dividend per share power of the Fund remains undiluted.

Fund dividend guidance

Fund Dividend Guidance

Source: Polar Capital, Bloomberg, March 2021. Note: Many AGM and dividend decisions were delayed from their usual place in the calendar year. We show the quarterly Fund dividend distribution above to help investors understand how we expect the quarterly split to be more normal in 2021.

We would argue that a dividend maintained through the pandemic today should be worth more than pre-pandemic, given a high degree of resilience should trade at less of a yield premium to other asset classes. In addition, despite recent bond yield moves, there remains a serious dearth of yield and equity dividend yields should compress given their scarcity value.


The derating of the types of stock we like, and have always liked, has been far too extreme in a market where consensus has, unusually, chased both cyclicality and growth. As the chart below shows, the cashflows of our defensives are materially undervalued relative to the index. The free cashflow yield factor (one of our key valuation metrics) is about as cheap as it has ever been. This should reverse in a normalising macro environment as the free cashflow yield factor is positively correlated with normalising bond yields.

Our view is that the macro outlook is improving, but consensus is materially overpaying for both cyclical and high-growth stocks. We would expect our types of stock to do well from here in the scenario where the macro improves and drives bond yields higher (thus helping our valuation discipline approach as growth sells off more) or in a scenario where the macro falters (our defensives look too cheap versus cyclicals in that scenario). In other words, we think that having been on the wrong side of two extreme divergences (growth mania valuations and cyclical recovery), we will benefit when these inevitably normalise.

Valuation characteristics

European ex UK Income

FCF Yield

P/E x

Div Yield %

P/B x


Median – Portfolio






MSCI Europe ex UK – Median






: Polar Capital, March 2021. Note: we use median data.