Diversify to pull off defensiveness

But the artificial environment that has come about as a result of policymakers’ response to the credit crisis has altered this standard lifecycle. Classic ‘defensive’ stocks and bonds have outperformed in all types of markets and now look expensive, which begs the question: are defensive companies still defensive?

The 10-year UK government bond is still yielding just 2.4 per cent, stubbornly below the rate of inflation (2.9 per cent in June). This has had an impact on equity markets. ‘Defensive’ companies – those with reliable earnings, stable growth and a secure dividend – have increasingly been used as ‘bond proxies’.

This trend has seen ‘safety’ become very expensive. In general, stocks traditionally considered defensive have continued to perform well at a time of market expansion when they would expect relatively weaker performance.

Clive Hale, partner at Albemarle Partners, says: “The classic defensive stocks of pharmaceuticals, utilities and tobacco have become expensive. Everything has gone up and investors are starting to question whether these areas are still ‘defensive’.”

David Hambidge, head of multi-asset at Premier Asset Management, goes a step further, suggesting it is wrong to see certain asset classes as always defensive: “The price you pay for an asset dictates whether it is defensive or not. Defensive parts of the equity market… have been bid up by people looking for bond alternatives.”

Toby Ricketts, chief executive and fund manager at Margetts Fund Management, points out with the risk-free rate so low, if a stock is truly defensive, it does not pay anything: “Before, investors could get 4 per cent on a bank account, while inflation was running at 2 per cent. Now, they receive 1 per cent in a bank and inflation is running at between 1.5 per cent and 3 per cent. With the risk-free rate so low, a portfolio generating 5 per cent is a long way from that risk-free rate.”

Anthony Gillham, manager of the Old Mutual Voyager Strategic Bond fund, points out that the solution to the ‘defensive’ conundrum may not lie within a single asset class. He says: “For example, floating rate notes will protect investors from rises in interest rates, [although] as a manager, we are looking to protect our portfolio against broader risks than just interest rates.”

He believes the one truly defensive approach for investors is to build a portfolio with sufficient diversification: “This is easy to say, but we need to ensure we are not inappropriately focusing on interest rate, credit or currency risk and missing the bigger picture.”

Mr Hale does not dismiss defensive stocks, saying that in a climate of low growth, they may well be worth the money investors are paying for them: “If a company can grow its earnings in a climate of weak growth, it may be worth the money that investors are paying for it.”

That said, it does leave them vulnerable if there are any revisions to growth.

He suggests one defensive option worth re-examining is large-cap. He points out that large-cap has underperformed for 10 years and some specialist large-cap funds, such as the Fidelity MoneyBuilder Growth, are well positioned to benefit from any change in sentiment towards large-caps.

However, it would seem that the answer to the thorny question of ‘what is defensive’ is that it is not a single asset class, it is an approach. ‘Defensiveness’, it seems, comes from diversification and a proper appraisal of valuation.

Cherry Reynard is a freelance journalist