Defense is no longer the best offense; ITV Shows Boring Is No Longer Beautiful

September 15, 2013, 3:21 p.m. ET

ITV Shows Boring Is No Longer Beautiful

It’s Tough to See the Picture Getting Much Brighter for the U.K.’s ITV

JOHN JANNARONE

Defense is no longer the best offense—at least that is what many investors have decided. The stock market’s surprise standouts earlier this year were some of its dullest, most defensive companies. Risk-averse investors chased stocks with dependable cash flows and stable dividend yields like Unilever UN +0.96% and Clorox CLX +0.68% . That resulted in a significant outperformance: In the year through April 22, global defensive stocks beat cyclical stocks by nine percentage points, says Philip Isherwood of Absolute Strategy Research. But since April 22, the outperformance has been almost completely reversed: Cyclical stocks have beaten defensive stocks by 10 percentage points. Why the change of heart? A likely reason is that shareholders are betting a broad-based earnings recovery will soon give companies the confidence to start investing in their businesses.One of the first places companies like to spend in a cyclical recovery is advertising, which can be switched on quickly but likewise reined in if the economy falters. Of all sectors, the media industry has the highest percentage of stocks that tend to rise when companies ratchet up their overall business investment, Mr. Isherwood says.

Indeed, media stocks have been among the top performers in the past few months. Take ITV, ITV.LN -0.71% the U.K.’s largest commercial broadcast-television company by revenue. The shares have risen nearly 50% since late April, when cyclical stocks came into favor.

ITV has particularly benefited because it depends heavily on advertising but has a large fixed-cost base. That means profits will rise significantly on any pickup in ad revenue. Since late April, consensus estimates for the company’s revenue have risen 4%, but estimates for net income have increased 10%, according to FactSet.

Yet the more important factor in ITV’s share-price rally was an increased valuation. The stock traded at just 12 times consensus forward earnings in late April but has risen to more than 16 times.

Given such multiple expansion, the question is how much better ITV’s prospects can really get. Consensus estimates reflect expectations for a roughly 3% rise in U.K. TV advertising spending next year, says Claudio Aspesi of Sanford C. Bernstein.

Certainly, any sharper rise in ad spending would feed into significantly higher earnings. Mr. Aspesi estimates that if TV advertising rises 7% next year, earnings expectations should be another 15% higher than current expectations.

But history suggests such an improvement is unlikely. Even in 2004, when the U.K. TV ad market was in the middle of an expansionary phase, growth fell just short of 7%, according to ZenithOptimedia. And at £3.3 billion ($5.2 billion), the current level of TV ad spending is only slightly below the peak of £3.5 billion in 2005.

ITV shares can probably hold on if the business-investment cycle stays on track. But, given the recent rally, any blips along the way will make investors want to change channels in a hurry.