The role of equities in a defensive portfolio

Equities are priced as a multiple of the earnings a company expects to generate in a year, so if earnings are falling sharply, then the valuations of equities will follow suit.  

Mark Jackson, investment specialist at JP Morgan Asset Management, says he is keeping the exposure his funds have to equity markets to a minimum in the current climate, and those equities he does own are large caps, and in markets he believes are less reliant on the outlook for the global economy.

We expect to see significant disruption to earnings over coming quarters Mark Jackson, JP Morgan Asset Management

He says: “We expect to see significant disruption to earnings over coming quarters. It is unclear how deep or sustained the downturn will be but as economic activity potentially recovers towards year end, we could see a sharp reversal in the earnings outlook for 2021.

"Within equities we have maintained a preference for the higher quality, less cyclical markets such as the US.”

Treat value shares with caution

Sunil Krishnan, head of multi-asset funds at Aviva Investors, says the present climate is not one in which advisers should take risks by buying the shares of companies that have fallen far in value.

A feature of the decade between the end of the financial crisis and the onset of the Covid-19 crisis was the sharp under performance of value equities relative to growth equities.

This typically happens when economic growth is relatively weak, and bond yields and interest rates are low.

Those economic conditions mean investors focus on the growth rate of businesses, rather than the price paid. 

Charlie Morris, chief investment officer at Atlantic House Investments says the problem with value investing in the near future is that “it’s a style that requires there to be lots of growth in the economy, and we are not going to get that.”

But Mr Flood is somewhat skeptical about the prospects for some of the traditional growth companies, such as those that make consumer goods.

He says: “The problem is that while those companies can still sell products, it is difficult to see how they can grow in future, for example, how they can sell more soap.

"People are buying the amount of soap they need now, which is fine, but they won’t increase the amount of soap they buy in future.”

David Coombs, multi-asset investor at Rathbones Unit Trust Management  says two types of companies will thrive in a recessionary world.

He says the first type will be companies that have very little debt, because one feature of a world in recession is that it becomes harder to raise capital. 

The second type of firm he believes will do better is one whose growth is structural, that is, based on changes in society rather than the health of the economy.

Healthcare and technology companies

He cited healthcare and technology companies as examples of this.

Suhail Shaikh, chief investment officer at Fulcrum Asset Management says: “At a time like this, when there is so much uncertainty about the future, I would look at companies that are benefitting from societal change, I would look at Microsoft who are capitalising on the change to cloud computing, and Amazon, who are capitalising on the growth of online shopping.

"An investor might look at those stocks right now and think they are trading at expensive valuations, but the trends they are benefiting from will be around for a long time.”

John Husselbee, head of multi-asset investing at Liontrust, says he prefers not to take a strong view on which investment style will come into favour at any one time, and instead tries to blend the various styles. 

Defensive stocks

Andrew Keegan, head of wealth portfolio solutions at BlackRock says in the market turmoil of March, those stocks that are traditionally defensive and less reliant on sourcing materials from China performed best. 

Mike Coop, fund manager at Morningstar, acknowledges that the traditional defensive stocks, in areas such as consumer goods have performed well during the turbulent period.

But he says the defensive qualities of those shares is already reflected in the valuations  of those companies.

He says this is an example of what he considers to be a significant risk investors face when compiling a portfolio: diversification risk.

Mr Coop says:  “The tendency of the market is to be pretty efficient at pricing assets based on what is going to happen in the short-term, but to be pretty bad at pricing assets for the longer term.

"That’s because investors prioritise what just happened.

"But those traditional quality defensive equities are already reflecting what could happen in the short-term.

"Owning those means you are exposed to those circumstances, but the risk is that something different happens, and so you are not protected from it.”

He says one example of such a risk would be if inflation rose sharply and economic growth was stronger than expected.

In such an environment, it is likely that those defensive consumer stocks would perform less well than the more cyclical stocks.

This is because the more defensive companies generally sell products for which there is constant demand, and demand does not rise when the economy does.  

Erik Weisman, chief economist at MFS, an investment management firm, says he expects the recovery in company earnings that eventually happens, to be at a much lower level than is typical of such recoveries from recession.

He says this is because of the way many companies behaved before the present crisis, taking on lots of debt, and not investing in the future growth of the business. 

He adds this behaviour has stored up problems which will keep earnings lower when the recovery happens.