Although I think of myself as a defensive value investor I’ve never really defined “defensiveness” in terms of the sector that a company operates in.
Usually I just look for companies that have a history of profitable growth and dividend payments stretching back at least a decade. If a company has been consistently successful over such a long period of time then in most cases that’s defensive enough for me (assuming of course that it makes it through the rest of my investment checklist).
However, I’m always looking for ways to reduce risk without obviously reducing returns and I think paying more attention to defensive sectors is one way to do it.
Simple rules of thumb to reduce risk for defensive investors
I already have a few rules of thumb which reduce my model portfolio‘s overall risk without being overly restrictive. These are:
- Number of holdings – Own 30 companies to increase diversification and stop any one holding having too much impact on the overall portfolio
- Industrial diversity – Have no more than 3 companies from any one FTSE Sector so that the portfolio is not overly exposed to the ups and downs of any one industry
- Geographic diversity – Invest so that more than 50% of the portfolio’s total revenues or profits come from overseas to reduce dependence on and correlation with the UK economy
- Position size – Rebalance any holding which grows to more than 6% of the portfolio, reducing it back down to around 3% and reinvesting the capital gains
As you can see there is no mention of which sectors the portfolio should invest in or stay away from.
Although I’m reasonably happy with those risk reducing rules of thumb, as well as the fact that the portfolio is full of consistent dividend payers, I would like to have a way of measuring how defensive or cyclical the overall portfolio is.
I can then use that information to make sure that, at a high level, the portfolio is weighed towards companies that can maintain and even grow their revenues, profits and dividends through the next recession.
Defining each company as defensive or cyclical
My starting point for this is to review the official FTSE Sectors and note whether they are defined as defensive or cyclical by Capita’s excellent quarterly Dividend Monitor (which you can find here, although you might have to search for it).
The sectors are defined in the Dividend Monitor like this:
- Aerospace & Defense
- Fixed Line Telecommunications
- Food & Drug Retailers
- Food Producers
- Gas, Water & Multiutilities
- Health Care Equipment & Services
- Mobile Telecommunications
- Nonlife Insurance
- Personal Goods
- Pharmaceuticals & Biotechnology
- Automobiles & Parts
- Construction & Materials
- Electronic & Electrical Equipment
- Financial Services
- Forestry & Paper
- General Industrials
- General Retailers
- Household Goods & Home Construction
- Industrial Engineering
- Industrial Metals & Mining
- Industrial Transportation
- Leisure Goods
- Life Insurance
- Oil & Gas Producers
- Oil Equipment, Services & Distribution
- Real Estate Investment & Services
- Software & Computer Services
- Support Services
- Technology Hardware & Equipment
- Travel & Leisure
There are various ways to find out which sector a company falls under. Many investment information websites show each company’s FTSE Sector and Sub-sector, but be careful because some, such as Morningstar, use their own system.
I tend to use the London Stock Exchange and Investegate sites as they’re both free, have search capabilities and RNS data (although I prefer Investegate as an investment research tool as it has 10 years or more of annual RNS information, making it easy to find annual reports going back a long way).
Measuring and controlling the number of defensive shares in the portfolio
It doesn’t take long to build up a table of a portfolio’s holdings and whether each one is in a defensive sector or a cyclical sector.
The question now is: How defensive do you want your portfolio to be?
If you’re obsessed with defensive stocks then of course you could limit yourself to only investing in defensive sectors. That’s an entirely legitimate approach, but it’s not the approach that I’m going to take.
Because I’m already restricting the portfolio to successful companies that have paid a dividend in every one of the last 10 years, I feel that even my investments in cyclical industries are relatively defensive. The model portfolio already holds companies from many cyclical sectors such as Mining, Banks and Oil & Gas Producers, but I don’t see the specific companies in question as being especially cyclical.
So the rule of thumb I’m going to use for both the UKVI model portfolio and my personal portfolio is this:
The portfolio should be at least 50% invested in defensive sectors (I’ll consider any cash in the portfolio to be a defensive investment as well).
Currently the model portfolio owns shares in 29 companies (29 instead of 30 because I sold one earlier this month and will replace it next month), 14 from cyclical sectors and 15 from defensive sectors. So it seems that by blink luck, and probably the fact that I’m mostly looking for steady dividend growers, the portfolio is already quite defensive.
The current weightings are 47% in cyclical shares, 45% in defensive shares and 8% in cash, which gives a combined defensive weighting of 53%.
Going forward I’ll re-check that weighting each month to make sure that any buying and selling of shares doesn’t cause the portfolio to drift away from its defensive core.
The difference between labels and reality
I’ll be the first to admit that the FTSE Sector categorisations above aren’t perfect, nor could they ever be. Calling a sector defensive does not mean that every company in it is defensive, and even if a company is correctly defined as defensive it does not automatically follow that it will behave in a defensive manner in an economic downturn.
However, I do think those defensive sectors hold considerably more defensive companies than the cyclical sectors, and that defensive companies are much more likely to maintain sales, profits and dividend payments in a downturn than cyclical companies.
And so for that reason I think using sector definitions is simple and practical way to understand and control the approximate defensive/cyclical nature of a portfolio.
Note: If you want to drill down to a finer level of detail (which I don’t because I don’t think it would necessarily add much value) then you could look at Sub-sectors rather than Sectors, using for example the defensive/cyclical definitions from the FTSE Cyclical and Defensive Index Series (PDF – see page 8).