Four unwanted defensive stocks going cheap

Professional investor Alec Cutler tips four unwanted defensives, including oil majors and drug companies, to buy now.

Each week, a professional investor tells us where he'd put his money. This week: Alec Cutler of Orbis Global Balanced Fund selects four out-of-vogue shares with promising futures.

With equity and bond valuations looking rich, it seems unrealistic to expect the good times to continue indefinitely. But many traditional defensive shares, such as food and other consumer-staples firms, appear expensive.

Instead, we prefer "unwanted defensives", such as oil majors BP and Royal Dutch Shell, and drug companies AbbVie and Bristol-Myers Squibb. They are currently out of vogue and have been volatile in the short-term, but may yet play the defensive role that they have in the past.

Two defensive oil giants

Our largest energy holdings are BP (LSE: BP) and Royal Dutch Shell (Amsterdam: RDSA). Both have adapted to low oil prices by cutting costs and reining in investment. They have reported growing free cash flow, and enough of it to cover cash dividends and capital expenditures with oil prices at $50 per barrel. Both have also announced share buybacks. While the trajectory of improvements is not certain, we believe the risks are in the valuations.

The firms have appeared risky during the energy downturn, but both have been defensive over full market cycles. Run for 20 years, their beta versus world stockmarkets is 0.8 (meaning they are less volatile than the overall market). Yet they are still perceived as risky despite their improving fundamentals, BP and Shell both offer generous dividend yields of about 6%.

Moated profits

AbbVie (NYSE: ABBV) is a pharmaceutical firm that lays claim to one of the world's best-selling drugs Humira, which is used to treat rheumatoid arthritis and other autoimmune diseases. Investors have fretted about competition, but the profits from the blockbuster drug are protected by two moats. The scientific moat comes from the nature of Humira. It is a biologic, a complex drug made with living organisms. Biologics are harder to copy than standard drugs, and so-called "biosimilars" may not deliver identical performance to the original drug.

The legal moat is patent protection. Key patents on Humira will expire after 2022 and bears expect this to be a challenge to Humira's competitive position. The shares of AbbVie, which yield 4%, were hammered last month after disappointing results from its Rova-T lung-cancer drug, but we view this as an overreaction and believe the current price does not fully reflect the long-term value of its broader development pipeline.

Solid long-term potential

Bristol-Myers Squibb (NYSE: BMY) is also under a cloud of pessimism despite long-term potential. Its Opdivo enhances the cancer-fighting potential of the body's immune system. But prior to our purchase, Bristol shot itself in the foot with a poorly designed trial.

While this was disappointing, it gives an opportunity for self-help. Bristol has now produced a redesigned trial that has a higher chance of securing approvals for the drug. If Bristol successfully addresses its execution risk, we think the market should come to recognise the quality of the business and its development pipeline.

AbbVie and Bristol have generated above-average returns on capital, while the healthcare sector has been defensive in market declines. At near-market multiples and with solid balance sheets and cash-flow growth, we believe both sell at attractive discounts to long-term value.

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