Vodafone Group (VOD)


What is a defensive stock?

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During market turmoil defensive stocks can provide a steady income. But what makes a stock defensive? Stephen Hayde of Close Brothers Asset Management attempts to define one.

The same attributes are always cited when investors attempt to define a defensive stock:

  • That they are non-cyclical. That is, they produce solid earnings irrespective of the performance of the larger economy.
  • That they offer higher-than-average dividend yields.
  • That they are linked to either basic human needs or addictions, so defensive stocks are often connected with food and drink, power, water, health, smoking and alcohol. The 'defensive' sectors are therefore typically utilities, telecoms, pharmaceutical, beverage, food retail and tobacco.

Of course, nothing is that simple and the history of investing is littered with examples of defensive stocks which failed to conform to their "safe haven" profiles. Similarly, thorough research may unearth company characteristics in less predictable sectors which should see them safely through downturns in the wider economy.

Some notable things to look out for which can trip up investors in defensive stocks include:

  • Overleverage - this has caught out many companies during the debt binge of the late 2000s with many companies such as the pub owners (Punch Taverns (PUB) and Enterprise Inns ()) and the banks still struggling to get their balance sheets back into decent shape.
  • Pension liabilities - poor stockmarket returns can soon lead to large pension deficits if the asset base is large. This deficit will need to be funded out of group cash flows, reducing the cash flows left for shareholders (i.e. BT Group (BT.A) and BAE Systems (BA.)).
  • Rights issues - companies may appear to have attractive dividend yields, but if they have large capital expenditure programmes as well, you may immediately be asked for the money back. National Grid (NG.), the electricity generator and gas distributor, did this in 2010 and concerns over future equity raising requirements remain.
  • Poor cash flow - whilst profits can appear healthy, cash flow remains king and is less manipulated than the profit and loss account. Companies like Connaught Group, the property-services group, highlighted the dichotomy between supposedly strong profits but weak cash flow, before entering into administration.
  • Pricing power - a number of pharmaceutical companies have been hurt by pricing cuts from governments in these austere times and also by patent expiries (leading to cheap generic competition).
  • Changing regulation - while difficult to predict as they change at the whim of the current government, they can have a large effects on investment (i.e. sudden changes in the North Sea tax rate, mobile phone termination rate cuts and the smoking ban).
  • Highly competitive markets - even stalwarts such as Tesco (TSCO), previously a reliable earnings grower, reset its profit expectations earlier this year amid accusations that the previous management had run the UK business too hard.

When stock-specific risks are so high, even in defensive names, it is important for portfolios to be diversified across a number of investments and asset classes. The Close Diversified Income Portfolio fund aims to deliver attractive income by investing in equities, corporate bonds, infrastructure and commodity investments.

You will find "traditional" defensive names among them, such as Vodafone (VOD), GlaxoSmithKline (GSK), Imperial Tobacco (IMT), Anheuser Busch (BUD), SSE (SSE) and Philip Morris International (PM).

However, I also look for other attributes too, chiefly among them strong balance sheets (for example Aberdeen Asset Management (ADN), Tullett Prebon (), ITV (ITV), Schroders (SDR), Cairn Energy (CNE) and Amec ()), real asset plays (i.e. Royal Dutch Shell (RDSB), Total (TTA), Gold and BHP Billiton (BLT)) and I also pay close attention to sectors displaying strong structural growth such as outsourcing (Babcock International (BAB)).

For my fund, which aims to deliver high, predictable income, this provides the required robustness with good risk/reward characteristics at a lower-than-average volatility.

Stephen Hayde is investment director at Close Brothers Asset Management.