Tactical investing is about being in the right place at the right time. For example, when the economy and stock market are bottoming out, you're likely to do much better by skewing your holdings towards industries most geared to recovery, or so-called 'cyclicals'. Likewise, as a bull market ends, you can preserve more of your capital by investing in 'defensives'.
While these terms are often spoken, they're pretty loosely used. Often, we fall back on rules of thumb to determine whether a company or industry is cyclical or defensive. For example, companies involved in life's essentials, such as food, beverages, utilities and tobacco are automatically assumed to be defensives, whereas those producing 'discretionary' goods and services are lumped together as cyclicals.
When weighing up a company or industry's cyclicality or defensiveness we can, and should, use better rules of thumb because the nature of companies and sectors changes over time. Especially over longer stretches, they may become more or less defensive or cyclical - and perhaps even switch sides altogether. Grasping this can help us see how they really did in the past and, more importantly, how they may do henceforth.
The accompanying table, History's Winners (see below), shows the top three best and worst performing UK sectors going right back to 1965. The top three are all considered defensive stalwarts, whereas real-estate investment trusts (Reits) and auto & parts are thought of as cyclicals (non-life insurance is not typically classified as either). As a result, you often hear the claim that defensives are a better bet not only in hard times, but also for the long run.
History's winners
While defensives may indeed beat cyclicals over time, that's not really much help to us when it comes to picking which sectors to buy for the future. To see why, imagine an investor in the mid-1970s had simply been told to stash his money in defensives for the next couple of decades. Going by vague rules relating to the characteristics of various businesses, his idea of what made an industry defensive may not have been the same as ours today.
History's winners
| Best | (%) | Worst | (%) |
|---|---|---|---|
| Tobacco | 19.7 | Auto & parts | 10.9 |
| Pharma & biotech | 17 | Non-life insurance | 11.6 |
| Food retail | 16 | Reits | 11.7 |
| Datastream; annualised total returns since 1965 | |||
For this reason, it's important to have a firm definition of defensiveness that can be applied in real time, rather than after the fact. In order to come up with one, we need to ask the basic question: defensive with respect to what? In other words, do we mean how a share performs at different stages of the economic cycle, its sensitivity to the wider stock market, its robustness in bear markets specifically, or how solid its dividends are?
Beta - or sensitivity to the broad stock market as a whole - is often wheeled out as a measure of defensiveness. It's easy enough to understand why. A beta of less than 1 indicates a share or industry that has tended to suffer less than one-for-one declines than stock market falls, and which rises less than the index during uptrends. Experience partly bears this out, too. The mining sector - a cyclical - currently has a beta of 1.47, while tobacco, a defensive, is just 0.6.
Top 5 UK defensives and cyclicals
| Most defensive | Most cyclical |
|---|---|
| 1. Gas, water & multi-utilities | 1. Technology hardware & equipment |
| 2. Oil & gas producers | 2. Auto & parts |
| 3. Electricity | 3. Fixed-line telecommunications |
| 4. Tobacco | 4. Industrial transportation |
| 5. Food producers | 5. Electronic & electrical equipment |
One problem with this, though, is that beta isn't static. It fluctuates over time, sometimes by a lot. At different moments in the past few decades, mining's beta has been as low as 0.26, and tobacco's has been as high as 1.57. Relying on today's beta alone, therefore, could throw up some funny answers as to what makes a defensive and a cyclical.
To get around this issue, I've come up with a scoring scheme that takes several factors into account. By looking simultaneously at various factors that contribute to defensiveness - as well as how they've shifted over time - we can hopefully get a deeper insight into the true characteristics of what we’re buying into, and use that to time our investments more deftly.
My scoring scheme takes five features into account:
■ Relative performance and the economic cycle: This explores how a sector has tended to do against the rest of the stock market when the outlook for the economy is either picking up or turning down. If a sector tends to outperform the FTSE All-Share when the OECD-leading indicator for the UK is heading upwards, it's behaving cyclically, whereas those that win when the leading indicator weakens are behaving defensively.
■ Beta: The sensitivity of a particular sector to moves in the broader stock market. A low beta is indicative of defensiveness while a high one is indicative of cyclicality.
■ Performance during market sell-offs: A key reason for holding defensives is trying to hold on to our wealth during times of equity turmoil. A sector that has done better than the wider index during most of the past five declines of 15 per cent or more is more likely to be a defensive in my system.
■ Maximum drawdown during the past decade: This looks at a sector's worst peak-to-trough decline during recent memory. By their nature, defensives are likely to suffer less dramatic slowdowns than cyclicals.
■ Dividend robustness: Defensive businesses are said to have firmer cash flows than their cyclical counterparts. This ought to be reflected in a more stable stream of dividends to shareholders. Those sectors that have suffered the lowest drawdowns in dividends paid out over the past decade are classed as more defensive, therefore.
Each factor carries equal weight in the model. Having worked out the results, I then average the rankings over the past decade in order to incorporate changing sectoral behaviour.
So what about my findings? The most important point that emerges is that defensiveness and cyclicality are not eternal properties. The make-up of the top five defensive sectors has shifted over time, although some have achieved fairly consistently high rankings over time, such as tobacco and, to a lesser extent, pharmaceuticals.
The character of some sectors has changed entirely over recent decades, with leisure goods going from defensive to somewhat cyclical. The oil and gas industry - which is often loosely described as cyclical - has gone full circle by behaving like a defensive in the 1970s, to becoming rather cyclical, and then returning to defensiveness.
An investor in 1975 would have been able to identify tobacco and pharmaceuticals as defensives based on my objective criteria. However, food retail - another success story since that time - would not have flashed up as being screamingly defensive. This industry only began to look defensive according to my model during the outset of the 1990s at the very earliest. There has also been flux at the cyclical end of the spectrum, although many of the same names have cropped up over the years, especially media, auto & parts and travel & leisure.
As of the end of June 2013, the top five UK defensives and cyclicals are shown in the table above. The most defensive sector is the gas, water and multi-utility sector, which has been represented in the top five ever since the year 2000.
Top 5 UK defensives and cyclicals
In my forthcoming IC Market Tactics report - which will be published soon on our website - I'll be looking in detail at the best moments to switch between defensives and cyclical industries, as well as the best way to get exposure to these areas.
