Since the financial crisis and market crash of 2007/8, defensive investing has become all the rage, and it’s easy to see why.
With what seems like an endless flood of bad economic news, tinged with talk of great recessions and depressions, investors want a “safe haven” where they can park their assets and insulate themselves from uncertainty and capital loss.
Defensive companies are the obvious starting point
Defensive investing at its heart is a simple concept. You look to invest in large and successful businesses which are predictable and not unduly affected by things like recessions.
The idea is to reduce uncertainty about future income and capital values, but without reducing returns, which is what would happen if you just held more cash.
The classic defensive stock is in the pharmaceutical, utility or consumer staple industry. They make things like toothpaste, soap and electricity which people need whether there’s a recession or not. They also tend to sell products which are price “inelastic”, in other words, if the price goes up people will keep buying.
These traits tend to result in defensive companies producing consistent and growing sales, profits and dividends, all of which is music to the ears of most investors.
Recent research has also supported the idea that low risk companies (or low “beta” to use the jargon) really have outperformed the market over time, which is the opposite of the standard mantra that you need to take on more risk to get higher returns.
So defensive investing provides a whole suite of attractive features to investors:
- A relatively low risk portfolio which is less stressful and easier to live with
- A steady income which should keep up with inflation
- Companies that mostly produce reliable, positive news, whether the economy is doing well or not
The hidden risk even the most defensive company can be hiding
There is a risk lurking out there which has nothing to do with the quality or defensiveness of the company you’re investing in. You could invest in the most defensive company in the world and still face this risk.
If you have unwittingly bought some shares which carry too much of this risk then their value could decline by 50% or more, even if the underlying company continues to do well.
This risk is called valuation risk, and it comes from owning companies where the share price is far higher than it deserves to be.
The good news is that it’s possible to increase returns and reduce valuation risk by making sure that when you buy defensive investments you get as much “value for money” as you can.
When it comes to the stock market, value for money typically means getting as much revenue, profit, cash flow and as big a dividend as you can get for your money.
In the same way that you would want to buy an investment property cheaply relative to its rent potential, a defensive value investor would be looking to by defensive companies as cheaply as possible too.
By combining a defensive stance with a keen eye for value, a defensive value investing portfolio should be:
- Defensive in nature: It should be a diverse collection of high quality, market leading companies with long histories of growing profits and dividends.
- Value focused: It should carry little valuation risk, i.e. it’s unlikely to fall excessively because it’s full of shares whose prices are already low. Because valuations are low, it should have higher earnings and dividend yields than the general market.
- Investing for the long-term: It should avoid frequent and costly switching from one investment to another by owning companies for years rather than months. It should be focused on companies which can be successful in the long-term, not which way the market will go next week, next month or next year.
There is only one problem with your judgment.
Value shares needs wind in their sails. No wind, nothing happens, a low P/E won’t bring the value share prices higher.
However there is a bit of wind as interest rates go up and the yield curve is steeper and steeper.
This makes banks to lend (as on a steeper yield curve banks make more profits and it is worth the risk of lending) to value companies helping value companies to make more profits and expand. So I bought myself a bank, Barclays. It was a special situation, with rights issues involved, but this is what I like, because these are situations when people miss-price assets, me included. Don’t follow me, I may be wrong.
My hope is that the regulator has calculated right the needed capital for Barclays and even if a few write – off are announced those won’t be big. I am relying on the regulator and that may not be good. I waited for this moment and I have not bought earlier, I remember last year lots of value investors saying let’s get some Barclays shares. Buying earlier a value share could be a disaster, I have some interesting examples.
Another special situation is Vodafone, itself a value company. So far Vodafone shareholders are not good at valuing Verizon shares. I have just heard today that one of the big stockbrokers in UK is advising their clients to sell Vodafone so they don’t have the trouble do dealing with US shares, US withholding tax etc. That’s music for my ears. I love forced sellers.
John Kingham says
Regarding “wind” I’m quite happy to wait for it because I think in most instances it isn’t predictable. if it is predictable then other, smarter and faster people would have gotten in ahead and pushed the price up already. I know you like a bit of momentum, but that’s not my style.
Sometimes the wind comes from the other direction, and value companies are very unstable at this type of wind.
People like Bernanke or Carney only need to open their mouths about tapering QE and value shares go South.
Not to say interventions from labour politicians about electricity prices.
The truth is that tapering will happen one day, we can’t stay on this drug for too long. Companies and investors will need to put up with it.
When are going to write about Royal Mail, I usually stay away from IPOs but this type I think it is worthwhile to get in from the beginning. I don’t have yet a final decision on RM
John Kingham says
I probably won’t write about Royal Mail, other than to say why I’m not writing about it. I don’t do IPOs. I only look at companies that have a 10 year history of dividends, so a company must have been in the market for that long at least. I’m not worried about missing out as there are plenty of other fish in the sea.