What is defensive value investing?

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 that are predictable and not unduly affected by things like recessions.

The idea is to reduce uncertainty about future income and capital values, 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 are 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 that 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 that can be successful in the long term and not focused on which way the market will go next week, next month or next year.