Risky defensives

What exactly is a defensive stock? The question’s a tougher one than you might think.

This year’s fall in Chinese tech giant Tencent (HK:0700) highlights the problem. It barely fell at all as markets tumbled last spring, suggesting it was a great defensive stock. Since February, however, it has lost almost 40 per cent as investors have feared the Chinese government will crack down on tech companies. Being defensive with respect to the pandemic does not mean being defensive with respect to regulatory change.

Which is not unusual. Many stocks can suddenly lose their defensiveness. Royal Dutch Shell (RDSA), for example, seemed defensive until it suddenly cut its dividend last year. Travel stocks seemed reasonably secure until the pandemic caused them to fall even more than the market last spring and bounce back more in the autumn: they went from being ordinary-beta stocks to high-beta ones very quickly. The same thing happened to transport stocks. They were dull utility-type stocks, until their beta soared during the pandemic.

The opposite can also happen. IT stocks have traditionally had a high beta. But they proved to be defensive during the pandemic.

My chart summarises such developments, showing betas based on the previous three years of monthly returns. During the tech boom-and-bust tech stocks had a high beta because they were sensitive to swings in investor sentiment. But they were reasonably defensive during the financial crisis and again during the pandemic. Transport stocks, by contrast have been usually defensive, except during the financial crisis and pandemic when their cyclical risk became more important.

There are many other examples of stocks losing their defensiveness or finding it. Banks were not unusually volatile until the financial crisis. Utilities have been mostly defensive, but became less so in 2019 as the threat of nationalisation increased. Oil stocks were defensive during the tech boom and bust because they were resilient to swings in investor sentiment, but have had higher betas since then as investors have focused more upon economic upswings and recessions. Telecoms have had the opposite pattern, being high-beta during the tech crash, but defensive since then as they have become ordinary mature utilities. And many of us thought that the US’s tech giants were risky because of their high valuations, but they proved to be defensive during the pandemic.

Defensiveness, then, is not a fixed quality of shares. It comes and goes.

We must ask: “defensive with respect to what?” A share that is resilient to swings in investor sentiment might not be so resilient to recession, or to rising bond yields, or to inflation, or to a pandemic – and so on.

And we might not be able to answer this question well. Defensiveness is something that is far easier to spot with hindsight than it is with foresight.

Is this a problem? Maybe not. It might instead be a solution.

There is one thing we know for sure – that defensive stocks do better than they should on average over the long-term. This has been found around the world, in different times, and even in assets other than equities. And it is true for various measures of defensiveness. It is one of the few robust reliable facts about stock picking.

But why do defensives outperform? One possibility is that investors cannot borrow as much as they would like and so express their bullishness by buying high beta stocks to get a geared position on the market. Another theory is that defensives are in fact risky for fund managers because they would underperform a strongly rising market, thus causing the manager to do worse than his peers. On both counts, some investors avoid defensives causing them to be underpriced – which means they offer good returns to the investor who is able to buy them.

There is, however, a third explanation. There is a risk with any defensive stock that it will lose its defensiveness. Which is nasty, because it means the stock will fall a lot when the general market is slumping. Investors cannot rely upon past defensiveness being a guide to the future. They therefore need compensation for taking on this risk. Such compensation takes the form of defensives beating the market on average. It’s a risk premium.

So yes, defensive stocks are riskier than they seem. But investors have historically been rewarded for taking on this risk. Which is more than can be said for many other types of risk: high-beta shares and Aim stocks, for example, have underperformed the main market over the long-term.

Defensive investing is not infallible. But then nothing is. It is, though, sensible and usually profitable as a long-term strategy – as long as you sometimes rebalance your portfolio to cope with the fact that defensives don’t stay defensive forever.