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These Stocks Have Been Left Behind in the Rally. They May Be Ripe for Picking.

S&P 500 utilities trade at an 18% valuation discount to the broader index.

David Paul Morris/Bloomberg

Defensive stocks have lagged the stock market. Many now trade at serious discounts and could be poised for big gains over the next year and beyond.

Since Sept. 23, the beginning of the current rally, cyclical value stocks—those that are most sensitive to the economy, such as manufacturers, banks, and oil stockshave largely led the market. And with the economic recovery expected to continue, earnings for cyclicals could explode in the near term.

Cyclicals have drastically outperformed defensive stocks—those that have stable profits no matter the economic environment. Since Sept. 23, the iShares S&P 500 Utilities exchange-traded fund (IUUS) is up 8%. The Vanguard Consumer Staples Index ETF (VDC) is up 8%. Meanwhile, the economically sensitive Industrial Select Sector SPDR ETF (XLI) is up 16%. The SPDR S&P Bank ETF ETF (KBE) is up 46%. The Energy Select Sector SPDR ETF (XLE) is up 23%. But cyclicals’ upside may be limited.

Defensive stocks now look attractive by some metrics, such as forward price/earnings ratios and dividend yields.

Health insurer stocks trade at roughly a 27% discount forward P/E ratio to the average S&P 500 stock, according to analysts at J.P. Morgan. Big health insurers have traded in line with the S&P 500 since 2000. Health-care earnings are expected to grow in the mid-single digits for the next two years, according to FactSet.

S&P 500 utilities trade at an 18% valuation discount to the broader index. S&P 500 consumer staples are 6% cheaper than the average stock on the index. Earnings for both sectors are expected to grow in the mid-single digits for the next two years.

True, strategists aren’t looking for earnings multiples to expand meaningfully from here, as low interest rates, which coax investors into equities, have little room to fall. But defensives’ multiples could have meaningful upside. Take Mondelez International (MDLZ), which trades at 20.7 times earnings. If it can trade up to 22 times earnings, then by the end of 2021—when it’s pricing in 2022 earnings—the stock could conceivably rise to $67.32, 15% above its current level.

Staples and utilities also offer dividends, providing padding to returns.

“There certainly is a good argument for utilities and consumer staples on a relative basis versus bonds,” David Miller, chief investment officer at Catalyst Capital Advisors, tells Barron’s. Consolidated Edison (ED) offers a 4.3% dividend yield. Kimberly-Clark (KMB) offers a 3.2% yield.

Even if defensive stocks lack a catalyst as the economy strengthens, they’re a decent bet beyond the next year.

Some defensive stocks have already begun to take off. Health-care insurance stocks UnitedHealth (UNH), Anthem (ANTM), and Cigna (CI) surged in early November after the presidential election, when the chances of a Democratic sweep in Congress fell sharply, closing the door to stringent regulation on the industry. Still, health insurers have been laggards year to date, leaving them cheap on a valuation basis.

Write to Jacob Sonenshine at [email protected]

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