Defensive stocks on the flight to safety

THE flight to safety is a well-charted journey, but not one without risks. Withdrawing from the markets when they are tumbling is a natural reaction, but for long-term investors generally counter-productive.

With financials plumbing new depths this week and commodities also heading south, investors are looking for sectors that have continued to offer returns. And as markets have fallen, some sectors have been more resilient than others. The drama surrounding financials in particular has obscured the fact that there are still companies in various industries performing well and still fundamentally strong, producing goods and services that people always need.

Also known as defensive stocks, these companies typically benefit – in the tough times at least – from relatively limited exposure to market and consumer sentiment. No matter how hard times get, some products and services are always needed, from fuel and electricity to toilet paper and toothpaste. These sectors are known as non-cyclicals because they are relatively unaffected by the seasons of the economic cycle.

In recent months the traditionally defensive sectors have generally met their remit, with tobacco, electricity, gas, water, utilities and pharmaceuticals the best-performing industry sectors. Tobacco stocks have been particularly resilient, up 5.92 per cent in the year to 6 October, and 2.44 per cent over the month.

Some of the UK's top managers have consistently maintained exposure to tobacco companies, most notably Neil Woodford of the Invesco Perpetual Income and High Income funds, in which British American Tobacco and Reynolds American feature prominently.

Conversely, some traditionally cyclical sectors are behaving as expected in a falling market, with those that depend on consumer spending, such as travel and leisure and general retailers, taking a battering.

What constitutes a defensive sector is unclear in this volatile market, however. For instance, supermarkets are often considered a defensive stock as people always need to buy food. But as Ben Yearsley, an investment manager at IFA Hargreaves Lansdown, pointed out, that doesn't necessarily mean they benefit from that demand in the hard times.

"They are being squeezed by rising costs and trying to keep their prices down, so their margins are tight. They are not that defensive at the moment."

Utilities aren't immune either, added Yearsley. "You have to consider utilities because people still have to use water, electricity and gas. But as prices continue to go up, people are becoming more energy efficient and that will have a long-term impact."

Some industries, most notably technology, are becoming increasingly defensive plays. In a stark contrast to the bear market of 2000-3, some managers have increased their weightings in technology, including Jorma Korhonen, manager of the Fidelity Global Special Situations fund, who invests 13 per cent of the fund in information technology companies. "These companies are profitable, have good balance sheets and are relatively stable," commented Yearsley. "But the big risk they potentially face is a total collapse in corporate spending."

The defensive qualities of technology depend on the area of the sector you look at, according to Frances Hudson, global thematic strategist at Standard Life. She cited Sage, which produces business software such as accounting packages, as a company likely to experience sustained demand. "Technology companies dealing with anti-fraud and regulatory processes could see their demand pick up," observed Hudson.

Of course, one traditional defensive sector – UK banks – is proving otherwise. But that is due to exceptional circumstances, said Hudson.

"What's happening in financials is structural, not cyclical, because banks, in a low-interest, low-return environment, were adopting increasingly risky models for two decades. However, what's happening in financials will prolong the cyclical downturn."

Some investors and fund managers are taking advantage of the low valuations of banks, positioning themselves to benefit from the eventual bounce. But those looking to maintain a more defensive position are focusing on the fundamentals.

"Managers in the UK are looking for the companies they believe will be able to sustain and grow dividends. More than a third of the companies in the FTSE100 are yielding over the ten-year bond yield, but lots of those won't be able to keep paying out at that level," Hudson explained. "So the focus is on cash-generating companies that don't need to borrow and have good balance sheets, and those benefiting from trends such as the strengthening US dollar."

The same principles apply to individual investors looking to shield their portfolios from the sectors most exposed to the downturn, added Hudson. "Look at the individual companies that you invest in – or that are being invested in on your behalf – and ensure they have solid balance sheets and are not going to the market to borrow money. It's not the time for anything heavily geared."

And of course, diversification has a massive role to play, as always. "Look at your asset allocation. If you want to be more defensive you would look at corporate bonds at the moment and move into equities later on, for example," suggested Hudson.