10 defensive shares for extra protection in uncertain economic times

Stockopedia's Ben Hobson believes having some defensive exposure in a portfolio during times of chaos could offer comfort. Here are some of the best plays around.

Making forecasts about the future direction of stocks and markets is notoriously difficult - and perhaps even pointless. Faced with an unpredictable future, the common guidance for investors is that a portfolio should be diversified to weather whatever the economy throws at it. But what does that really mean?

Most investors think of diversification as a balancing act between minimising the damage of single stock disasters and the costs and effort of managing lots of positions. But there's more to diversification than just numbers of stocks...

The cyclical nature of business and economies means that different stocks can behave very differently depending on the conditions. So it's worth taking account of this when it comes to building an all-weather portfolio. 

If your positions all tend to do well when the economy is booming, then things could get sticky if a recession or economic shock suddenly emerges. But if your stocks are all safe havens in times of economic strife, it's unlikely you’ll get the big upside when the economy takes off. 

To understand this better, you can map the stockmarket based on three main super-sectors: Cyclicals, Defensives and Sensitives. Between them, they account for the 10 main business sectors:

●    Cyclicals: Basic Materials, Consumer Cyclicals, Financials
●    Defensives: Healthcare, Consumer Defensives, Utilities
●    Sensitives: Industrials, Energy, Telecoms, Technology

Cyclical sectors are generally the most sensitive to macro trends and the health of the economy. Among them are high street retailers and housebuilders. These industries have done well in the years after the financial crisis but they face pressure when consumer confidence starts to waver. With uncertainties like Brexit and rising interest rates on the horizon, cyclicals can become volatile.

Defensives, on the other hand, tend to be less reliant on the domestic economy because they sell goods that are in constant demand. They include pharma companies and utility groups, which are heavily regulated and have much more predictable outlooks. 

Defensive stocks often pay dividends, which means that some see similarities between them and assets like bonds. The catch is that when bond yields start to rise - which they have been recently - it can put pressure on the prices of defensive "bond proxy" stocks as investors turn away from them.

Screening for defensive options

Whether or not you think that the stockmarket could be buffeted by volatility in the coming months, keeping an eye on your defensive options could be useful. There are various considerations here, but this simple screen looks for stocks in defensive sectors that are in the top 20% of the market based on the attractiveness of their overall quality, value and momentum (StockRank). Their history of volatility (based on 3-year standard deviation) should classify them with a Risk Rating of either Balanced or Conservative. Plus they need to have seen a positive price gain over the past year.

Source: Stockopedia         Past performance is not a guide to future performance

An interesting result from this set of screening rules is that the companies have a wide range of market-caps - suggesting that defensive options can be found right across the market. Among the smallest here are Jersey Electricity and Finsbury Food, ranging all the way up to large-caps like Smith & Nephew and J Sainsbury. Based on yield, this list is topped by the London-listed agro-industrial company, MHP, on 6.1%.

In the days after the EU referendum in June 2016, when the value of sterling fell sharply, defensive stocks held up better than most. In times of chaos they can suddenly be in high demand, which pushes their prices higher. So having some defensive exposure in a portfolio could offer comfort ahead of periods of uncertainty. While these kinds of shares don’t always offer big upside in bull markets, their more predictable nature and dividend payouts can be a reasonable trade-off.

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