HOW DEFENSIVE ARE DEFENSIVE STOCKS REALLY?
Defensive stocks are companies whose products consumers can’t do without. In tough economic times, such stocks seem to be a no-brainer for investors. But are these stocks really such a safe bet?
defensive stocks are prevalent in industries where companies are mainly focused on delivering cheaper products or services that consumers find hard or impossible to manage without. Typical examples of areas in which defensive investments can be found include food manufacturers and retailers, medical care and tobacco sectors.
What makes these products and services defensive investments is the fact that they cannot be stopped or put on hold simply because the economy is suffering. And yes, the alcohol and tobacco industries are no exception. My grandfather always used to say: “When food prices increase, people may buy a little less food. But when alcohol prices increase… they buy even less food.” Further, people must eat, and when they become critically ill or injured, they must get medical help, regardless of how much the economy is suffering.
Defensive stocks are known for their ability to withstand periods of economic volatility and market declines, but unfortunately, the opposite is also true. Historical data clearly shows that defensive stocks usually struggle to keep up when the market thrives. On the other hand, businesses such as car dealerships, mobile phone providers, insurance companies and banks, which are much more sensitive to market fluctuations, tend to benefit from a growing economy, but tend to suffer when consumers’ finances are under pressure.
Defensive stocks are statistically recognisable due to the fact that they have a beta indicator of less than 1. In simple terms, a stock with a beta of 1 means that for every percentage point that the market rises or falls, your share/stock also moves up or down by the exact same percentage. A beta of 0.8, therefore, would mean that your share/stock will only rise by 0.8% for every 1% that the market rises, but that it will also only decrease by 0.8% for every 1% the market declines.
I chose four random shares/stocks that could be classified as defensive stocks, namely AVI (food manufacturer), British American Tobacco, Netcare (medical care) and Spar (food retailer), and compared their rolling 12-month price movements to more cyclical companies such as FirstRand, Imperial, MTN and Sanlam. The results were in line with the definition of defensive stocks. They didn’t perform as well as the cyclical stocks when the market thrived, but they shone brightly whenever the market pulled back.
What concerns me is the fact that many investors started to consider defensive stocks as a safe haven when interest rates started to enter an upwards cycle about 18 to 24 months ago. The more concerned investors become worldwide, and the higher market risks become, the more cyclical stocks are being exchanged for defensive stocks.
When we compare the four defensive stocks’ historical price-to-earnings ratios (P/Es) to that of the more cyclical stocks, you will see that the average historical P/E of defensive stocks was relatively close to the average historical P/E of the cyclical stocks after the great correction of 2008 (14.1 times). Seven years down the line, however, these defensive stocks’ average historical P/E is trading at 22 times, compared to the cyclical stocks’ P/E of 13.3 times. My question is, how defensive are defensive stocks really at these current boiling levels?
These tendencies always remind me of the latest diet trends. Until recently, fat was your worst enemy, making carbohydrates the safer food option. These days you’re allowed to stuff yourself with anything fatty while carbohydrates should be avoided at all costs. I’m not saying that defensive stocks are bad investment options, but a proper balanced diet has never hurt anyone.
British American Tobacco Tobacco manufacturer
AVI Food manufacturer
Spar Food retailer
Netcare Medical care