ARTICLES NOVEMBER 2019
What’s a defensive stock in 2020?
The definition of a defensive stock has evolved in the age of disruption.
- Defensive stocks aren’t easy to define in the age of disruption.
- Traditionally defensive companies may have trouble living up to their reputation.
- Some growth-oriented stocks may display defensive characteristics.
What’s a defensive stock? It’s a simple question that used to have a simple answer. In years past, defensive stocks were reliable, conservative, boring investments in the consumer staples, utilities and health care sectors. These companies generated steady cash flows, paid solid dividends and didn’t have “dot-com” in their names.
More recently, however, there’s been a discernable shift in investor views of what constitutes a defensive stock. Many businesses that were previously considered defensive — including food, tobacco and telecommunications firms — have been disrupted by technology advancements, changing consumer behaviour and fierce competition in a global economy.
As investors search for defensive stocks ahead of the next recession, they may find that a broader definition is warranted.
“A defensive stock is one in which a company’s earnings and revenues have the potential to hold up fairly well during a recession,” explains portfolio manager Alan Wilson.
“So the key question is, will the companies that have displayed defensive characteristics in the past continue to do so in the future? I’m not so sure about that,” Wilson says. “It may depend a great deal on the cause of the next downturn.”
Food for thought
For decades, food companies have been considered classic defensive investments. People need to eat, right? Indeed, during the global financial crisis in 2008–2009, some food-related companies held up relatively well compared to the overall market, including McDonald’s, Panera Bread and Walmart. But that was before the business found itself being disrupted by new entrants like Amazon, changing consumer tastes, massive consolidation and competition from online food delivery startups.
Kraft Heinz is one example of a food industry giant that stumbled as consumers increasingly embraced fresh food and organic options over processed products. In February, Kraft Heinz took a US$15.4 billion write-down on the value of some of its struggling brands, which include Velveeta, Maxwell House and Miracle Whip. The company also cut its dividend by 36%.
"Traditional industries like the food business face some challenges and may not be as defensive as we once thought,” says portfolio manager Jonathan Knowles. “Like so many other industries, it’s going through a period of disruption that is altering the investment landscape.”
Is the best defense a good offense?
Knowles believes the definition of a defensive stock has changed in recent years. It may now include companies with strong earnings growth, innovative products, pricing power and the ability to shake up the status quo in established industries.
“Lots of people might disagree with me,” Knowles says, “but I would argue that a company like Google parent Alphabet has some defensive characteristics, based on its cash flow and dominant position in the internet search market.” Knowles puts Facebook in this category, as well.
These are growth-oriented companies by most measures, Knowles adds, but they may still hold up well in a sustained downturn based on their robust earnings potential, ability to innovate and relatively attractive valuations.
Examining growth companies
Defensive stocks are often associated with traditional value investing, but select growth stocks certainly shouldn’t be overlooked, adds Lisa Thompson, a portfolio manager with Capital Group.
“In some of the relatively minor market downturns we’ve seen in recent years, there are many examples of quality growth companies that have done better than the overall market,” Thompson explains. “They tend to be companies with strong management and solid balance sheets that can navigate through difficult environments.”
Moreover, some growth-oriented stocks can show countercyclical characteristics. One example is CME Group, the Chicago-based exchange company that facilitates trading in derivatives, options and futures. CME’s revenue has tended to rise during periods of extreme market volatility.
As trading activity increased, CME’s stock price has generally done the same — as happened in the fourth quarter of 2018 when the S&P 500 declined by nearly 14%. During that period, CME’s stock price rose 12%.
Utilities stocks may also maintain solid defensive characteristics in a downturn, provided they are run by competent, experienced management teams and operate in a market with a stable or growing population.
Search for quality dividends instead of “value”
Just as it used to be easier to identify defensive stocks, it also used to be relatively straightforward to pick a defensive investment strategy for your portfolio — just shift to a value-oriented index and call it a day.
But it’s important for investors to understand that value stocks aren’t always defensive. For example, many stocks that are included in popular value indices don’t pay dividends and don’t have high credit ratings. About 22% of stocks in the Russell 1000® Value Index paid dividends of less than 0.1% in 2018, and roughly 40% of the rated companies in that index carried ratings of BBB– or lower. Companies with questionably high debt levels are also not uncommon.
A missed debt payment or a ratings downgrade could send share prices tumbling. A better strategy may be to focus on higher quality companies that are most likely to maintain consistent dividend payments, says Capital Income Builder™ (Canada) portfolio manager Joyce Gordon.
“It all comes down to fundamental research on individual companies,” Gordon explains. “Different types of companies can potentially provide downside protection in different types of markets. It’s our job as investors to figure that out — one company at a time.”
Joyce Gordon is an equity portfolio manager with 39 years of investment experience. She holds an MBA and a bachelor’s in business finance from the University of Southern California.
Jonathan Knowles has 27 years of investment experience, all with Capital Group. Earlier in his career, Jonathan covered pharmaceuticals, chemicals, support services and small-cap companies as an investment analyst. He has an MBA from INSEAD, France, as well as a PhD in immunovirology and a bachelor's in veterinary science from the University of Liverpool, U.K.
Lisa Thompson has 30 years of investment experience, 24 with Capital Group. Earlier in her career, she covered companies in Latin America, emerging Europe, West Asia and Africa as an investment analyst. Lisa has a BA in mathematics from the University of Pennsylvania and is a CFA charterholder.
Alan Wilson is a portfolio manager with 34 years of investment experience. He holds an MBA from Harvard and a bachelor's in civil engineering from MIT.