You often hear the word ‘defensive’ applied to certain stocks and sectors, but what does it mean and can buying ‘defensive’ stocks really help your performance as an investor?

In a word, yes, because they dial down some of the risk which is inherent in markets because they tend not to be very volatile unlike most ‘cyclical’ or ‘growth’ stocks, but it’s how you use them which matters.

Defensive stocks might be of interest to investors right now who are concerned about increased volatility thanks to developments in AI and in the new US administration’s trade policy.

LOWER YOUR VOLATILITY

A fund manager friend of Shares once described his strategy as ‘making more on the straights and losing less on the curves’, by which he meant he tried to outperform the market not just on the way up but also on the way down by having a smaller drawdown, or losing less money, than the benchmark.

His approach was to hold a mixture of high-beta and low-beta stocks, so when market sentiment was positive his high-beta names would gain more than the index and when sentiment turned his low-beta names would limit the downside.

In finance terms, beta is a measure of volatility where stocks with a beta of more than one move more than the index and those with a beta of below one move less – or are less volatile – than the index.

In extreme cases, stocks can have a negative beta which means they are totally uncorrelated – or even inversely correlated – with the market, although they are few and far between.

The advantage of owning low-beta stocks as well as high-beta stocks is that, while they don’t increase your chances of beating the market when it’s going up, they are less risky when the market comes down, with some even being seen as a ‘safe haven’ when volatility picks up.

Without getting too technical, beating the market on the way down as well as the way up is measured by the Sortino Ratio.

Not many fund managers refer to this, but as you would expect old hand Terry Smith, the founder of Fundsmith and manager of Fundsmith Equity (B41YBW7), makes a point of citing it in his annual shareholder letters, including his 2024 review.

‘Since inception, the fund has returned 2.7% per annum more than the index and has done so with significantly less downside price volatility as shown by the Sortino Ratio of 0.87 versus 0.60 for the Index. This simply means that the fund has returned about 45%, ((0.87÷0.60)-1)x100, more than the index for each unit of price volatility.’

TYPES OF DEFENSIVE STOCKS

Defensive companies come in many shapes and forms, and can be ‘value’, ‘growth’, or even both at the same time.

Typically, defensive companies are those which aren’t tied to the economic cycle or an obvious business cycle – unlike energy and mining companies, for example, which move according to global commodity prices, which in turn are dictated by the economic cycle, making their earnings more cyclical and therefore their share prices more volatile.

In contrast, pharmaceutical firms or tobacco makers are less exposed to cycles and more to steady, long-term drivers of demand – in the case of pharmaceuticals, demand is generally increasing, especially for new products, while for tobacco companies demand for their products is generally decreasing, due to greater health awareness, although innovation can help stave off some of the decline.

On that basis, British American Tobacco (BATS) could be seen as a classic defensive stock, and sure enough it has a beta of 0.76 according to Stockopedia, which means its shares are roughly 25% less volatile than the FTSE 100.

BAT shares several other characteristics common to ‘defensive’ stocks – its earnings grow steadily, albeit not very quickly, it trades on a low PE (price to earnings) ratio, currently less than nine times 12-month forward forecast profits against 13.2 times for the index, and it has a relatively high yield of 7.5% compared to the average of 3.4% for the index.

In contrast, a much less obvious defensive stock would be scientific instrument maker Halma (HLMA), which grows its earnings much faster than BAT, is on a forward PE ratio of 30 times and has a dividend yield of less than 1%

As well as increasing its top and bottom line on average by double digits each year over more than four decades, and enjoying an attractive ROCE (return on capital employed) of around 15%, the shares have a beta of 0.49 which means they are less than half as volatile as the FTSE 100, so in the event of a sell-off they are likely to fall less than the benchmark.

Disclaimer: The author owns shares in British American Tobacco, Fundsmith Equity and Halma.

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