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Do defensives win in times of turbulence?

Rather than taking a blanket defensive or cyclical approach, you need to understand the full picture.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Brexit remains a mystery, trade disputes rumble on and fears of a European recession are building. It’s safe to say a few things have investors worried at the moment.

It’s in times like these we hear about investors taking a defensive approach. Not quite battening down the hatches, but investing in companies whose performance isn’t as dependant on the wider economy as others.

Protection against the bad times plays an important part in a balanced portfolio but it’s not the whole story. Investors will need to look beyond the defensive label to understand if they’re really diversified.

Defensive or cyclical – what to look out for

You can typically split the market into cyclical and defensive companies. The performance of cyclical companies tends to be tied to the wider economy – more so than defensive companies. A growing economy is often characterised by high employment, strong consumer spending.

Cyclical – a cyclical business is particularly sensitive to the wider economic cycle. Sales are usually higher when the economy is booming and lower during a downturn.

Defensive – a defensive business is less sensitive to economic cycles than cyclical businesses. They tend to sell everyday items where the demand doesn’t change as much, like food and drink.

However, when the economy slows, nice to have purchases like a new TV or car are delayed. However, we still need essentials like food, electricity and water.

This can see cyclical companies outperform in times of economic growth but suffer more in downturns. Defensive companies often follow a similar pattern but see less improvement when times are good and less damage in tougher times.

As an example, the chart below shows how the cyclical construction materials sector has tended to have a bumpier ride than defensive food and drink companies.

Cyclical and defensive returns over time

Past performance is not a guide to the future. Source: Thompson Reuters Eikon, 12/09/2019

Once defensive, always defensive?

Given the current state of play, lots of defensive businesses are very popular right now. But that itself can come with risks.

Current valuations could see you paying a premium for steady revenue. We think Unilever’s diverse revenue base and international demand give it important defensive qualities, but it’s currently trading on a price-to-earnings (PE) ratio of 20, compared to a longer-term average of 18.

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Remember that what once made a company more defensive or more cyclical can change, so it’s important to keep in mind what you’re trying to achieve.

For example, many think of utility companies as businesses that can provide shelter against the economic cycle while producing stable earnings and dividends. But there are risks attached.

The Labour Party, though not in power, proposes to renationalise the water and electricity industries. Shareholders could lose ownership and be paid less than the market value for their shares. Political and societal factors are up for debate, but the fact is that’s hurt share prices recently. With the possibility of another general election coming up, it’s something to bear in mind.

What renationalisation could mean for investors

Tobacco has also got sector wide headwinds, not least because of increased regulation in the US. British American Tobacco, a traditional defensive stock, currently has a PE of 8.7. That’s 40% below its 10-year average.

It’s not just health regulators impacting the shares either. Lots of big institutional investors, like government pension schemes, have been shifting away from the sector. While trends come and go, be aware this is a gap in demand for the shares that might never come back.

Imperial Brands isn’t as exposed to the US as British American Tobacco, but has been suffering a similar fate, currently trading on a PE of 7.6 – about a third below its 10-year average.

See the British American Tobacco share price and charts

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See the Imperial Brands share price and charts

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Look before you leap

Style is an important consideration, but we think substance comes first. Rather than taking a blanket defensive or cyclical approach, you need to understand the full picture. Think about what the drivers of the business are now and what they’ll likely be in the future.

Finding the right price for quality companies

The author owns shares in Imperial Brands plc.

Unless otherwise stated estimates are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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