How defensive is defensive?

Defensive stocks are predominantly found 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 where defensive investments can be found include food manufacturers and retailers, medical care and the tobacco and alcohol industries.

The fact that delivering these products and services cannot be stopped or put on hold just because the economy is suffering, is exactly what makes them defensive in nature. 

And yes, that includes the alcohol and tobacco companies. As my grandfather always used to say: “When food prices increase, people will buy less food. But when alcohol prices increase, they will buy even less food.” 

Jokes aside. The point is that people have to eat and they have to get medical attention if they become critically ill or injured, regardless of the state of the economy.

Defensive stocks are well-known for their ability to withstand periods of economic volatility and market declines, but unfortunately the opposite is also true. 

Historical data shows that defensive stocks usually struggle to keep up when markets thrive. 

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 suffer when consumers’ finances are under pressure. 

Hence they are called cyclical shares. 

Defensive stocks are statistically recognisable due to the fact that they have a beta indicator of less than 1. 

Any share/stock with a beta of 1 means that for every percentage point that the market rises or falls, that particular share/stock should also move up or down by the exact same percentage. 

A beta of 0.8, therefore, would mean that the share/stock will only rise by 0.8% for every 1% the market rises, but it will also only decrease by 0.8% for every 1% the market declines. 

I chose five random shares/stocks that can be classified as defensive stocks: Distell (alcohol), AVI (food manufacturer), BAT (tobacco), Mediclinic (medical care) and Spar (food retailer), and then juxtaposed their earnings movements with that of the FTSE/JSE All Share Index over the last three years. 

The idea wasn’t to evaluate their price movements, because we know that these five shares took quite a beating at times over the last three years. 

I wanted to determine how these companies’ physical earnings performed during this very difficult period (last three years). 

The results were in line with the definition of a defensive stock. 

Despite the fact that these defensive stocks with an average beta of 0.69 didn’t rise as sharply when compared to the JSE, their earnings growth occurred at a far more stable and defensive pace. 

I’m more worried about the recent disappointing GDP figures published by Stats SA, and the possibility that the worst of it isn’t quite over yet. 

And the fact that the more worried investors worldwide become, and the higher the market risk, the more the cyclical shares (like banks, for example) are being swapped for defensive shares.  

When we take a look at the historical price-to-earnings ratio (P/E) of the same five defensive shares over the last three years, you will see that they also became “cheaper” – no different to the JSE. 

In fact, these five shares’ P/Es are now trading at lower relative levels than the levels of three years ago when compared to the JSE. 

What I’d like to know, is if global markets were to become even more volatile, wouldn’t this be a good way to ‘protect’ yourself? 

I’m not suggesting that investors should switch all their cyclical shares/stocks to defensive stocks, but rather that you re-evaluate your portfolio if it only consists of cyclical shares. In the end, it boils down to having a well-diversified investment portfolio, which should benefit from any kind of investment environment.

Schalk Louw is a portfolio manager at PSG Wealth.

This article originally appeared in the 4 July edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.