What does defensive investing mean today?
As investors reflect on the damage inflicted by the coronavirus outbreak on their portfolios in recent weeks, they may be looking for a way to build in greater resilience. However, traditional defensive investment strategies may not be the answer
Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
These have been a frightening few weeks in financial markets. The impact of the coronavirus on the global economy is not yet clear and while policymakers have provided considerable support, an economic slowdown appears inevitable.
‘while policymakers have provided considerable support, an economic slowdown appears inevitable’
While this is no time to make wholesale changes to a portfolio, it is an opportune time to build resilience into a portfolio where possible.
But what does a resilient portfolio look like today? This isn’t straightforward. Many of the old rules about how to invest more defensively do not apply.
Moving into government bonds, for example, no longer looks like a particularly ‘safe’ strategy given the low yields on offer.
The same is true for the stock market. Traditionally defensive areas are currently in high demand and, as such, may not provide the resilience a portfolio needs.
In this environment, we believe it is vitally important to look at each company on its fundamentals, rather than succumb to broad-brush thinking on what ‘should’ work in a maturing cycle.
The usual suspects
For example, a natural choice for this stage in the market cycle might be areas such as real estate, consumer services and communications.
‘Many of the old rules about how to invest more defensively do not apply’
However, these areas have been caught up in the ‘bond proxy’ trade that has been so persistent for the past five years.
‘Bond proxies’ are where those companies with bond-like qualities have been adopted by investors moving out of fixed income into the stock market in search of higher yields.
Prices are simply too high for these areas to act as a defensive option in a more difficult climate.
On the other hand, we are not tempted to compromise on quality in this environment, no matter how cheap share prices have become in certain segments of the market.
Loose monetary policy has kept many companies afloat that might not otherwise have survived. Debt has proved a poison chalice in the current environment and vulnerable companies have quickly showed the strain.
Many ‘cheap’ companies have become even cheaper and may continue to do so.
We want to be invested in those higher quality companies whose earnings we can reasonably forecast into the future.
These companies are likely to be in a better position to weather the incoming storm.
Today, we are finding more of those companies in the energy and financials sectors, despite these being seen as more ‘cyclical’ areas.
‘invested in those higher quality companies whose earnings we can reasonably forecast into the future’
We can also find companies that meet our criteria in the technology sector – though, admittedly, in niche subsectors rather than some of the expensive global technology giants.
While we are both value, quality and income investors and technology does not usually fit the bill, investors need to look beyond those labels in today’s environment.
For any income strategy, it is important to be invested in companies that are generating income organically in this environment.
Too often, companies are paying out more than they can realistically afford based on their earnings.
This tactic leaves them particularly vulnerable in a weaker economic and market environment.
For us, particularly in the current climate, it is vitally important not only that a company can pay its dividends today, but that it can grow its dividends tomorrow.
We base our judgement on cash flow; what is left for the shareholder when all a company’s other commitments have been paid.
‘this realistic appraisal of a company’s true merits will be vitally important’
Good cash flow means the management team has been disciplined and that the company is likely to have competitive resilience.
In terms of how this looks in the portfolio, it means that the companies we hold are diverse – from large US banks to Microsoft – and they do not fit the natural assumptions about ‘quality’ or ‘defensive’ or ‘value’ stocks.
It is what we see that is important, not the characteristics the market assigns to these stocks.
This is a recognition that the world is changing – information technology can be the new consumer staple, for example.
We believe this realistic appraisal of a company’s true merits will be vitally important as we move into a more challenging environment.
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