How to find defensive shares that can weather stock market storms

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The sharp stock market sell-off earlier this year served as a reminder that volatility is par for the course in investing. During such periods, defensive growth businesses are expected to hold up better than those that are more cyclical and sensitive to economic cycles.

In this episode, Kyle speaks to James Thomson, lead manager of Rathbone Global Opportunities Fund. Part of the fund is devoted to recession-resistant businesses, including companies that are not as closely linked to the economic cycle, and those where demand is more predictable. James explains what he looks for in ‘weatherproof businesses’ and shares stock examples.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On The Money, a weekly look how to get the best out of your savings and investments.

This is our last episode before we take a short two-week summer break. We'll be returning on Thursday 4 September. In this episode, I interview James Thomson, who has been lead fund manager of the Rathbone Global Opportunities Fund since 2003.

A portion of the fund is devoted to less economically sensitive and recession-resistant stocks, which is the focus of this week's episode. In the interview, James runs through the qualities he likes to see in what he calls “weatherproof holdings” and names some stock examples.

The interview took place towards the July, so let's get to it now.

So, James, you have for a very long time ensured that the Rathbone Global Opportunities Fund has around 20% of its holdings in what you call “weatherproof stocks”. Could you explain when you first decided to put this defensive buffer in place? And could you define what a weatherproof holding is to you?

James Thomson, lead fund manager of Rathbone Global Opportunities Fund: Well, after the great financial crisis of 2008, the fund performed very poorly as many did, but I felt I needed to learn from the episode and get better as a fund manager.

While the fund was diversified by country, sector and size, I think it was clear that it was just too adrenaline-filled with economically sensitive stocks that traded as a group during the crisis.

During market dislocations, investors tend to punish companies with the greatest earnings sensitivity to the economic cycle. For example, retailers with discretionary sales, advertising businesses, industrial order-driven businesses, or tech companies where the high multiple makes them more sensitive to even small changes in demand.

Weatherproof holdings have less of a link to economic growth, demand for their products and services that is less correlated to GDP growth.

This is the defensive part of the portfolio, usually about 20 to 25% of the fund. It tends to be a drag on overall performance during bull markets, but also provides a buffer during bear markets or a sudden crisis.

So, I think what we've done is effectively clipped the tops and the tails, but that should provide a steadier ride in a world of inconsistent returns.

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Kyle Caldwell: Could you talk through the types of qualities that companies need to have to be in charge of their own destiny in being less economically sensitive?

James Thomson: Yeah. Lower economic sensitivity, staple-like demand, and recession-resistant products or services, where demand is a need rather than a want or nice to have. Some obvious examples would be pharma, non-elective healthcare, groceries, utilities, tobacco. Interestingly, it's not just low valuation that makes a weatherproof stock. Cheap doesn't mean safe, and the idea that the low valuation implies a margin of safety is a mirage.

For example, commodity stocks often trade on low valuations. That's because the revenue and earnings streams are volatile and closely linked to economic growth or unpredictable commodity prices. So, they definitely wouldn't count as weatherproof. We want well-managed, high-quality, resilient, low variable, revenue-variability businesses. But they still have to have the hunger to innovate and improve, even if the growth rate pales compared to some of my more racy growth stocks in the rest of the portfolio.

Kyle Caldwell: So, you've highlighted the key ingredients that you look for in a weatherproof stock, and you've highlighted some sectors that fit into the weatherproof stocks and those that don't.

Could you highlight examples of holdings that you own today? I'd also be really interested to find out which weatherproof holding you've had the longest in the fund, and which stock has been the newest name for this part of the portfolio.

James Thomson: We're trying to find weatherproof companies that are flying under the radar.

It's obvious that a utility or a consumer staple is a defensive stock, but maybe we can be a bit more imaginative and not only win during market meltdowns. We also want to participate in all-market environments.

Holdings in this part of the portfolio have changed too over the years, but the longest-standing holding has been there since 2014. Rollins Inc (NYSE:ROL) is an American pest control business, not obviously a defensive business, especially in the British climate, but in the hot, sticky southern United States, pest control is considered an essential service, the fourth emergency service.

And it's not a service that's moving DIY. Most of us don't want to do a little pest control in the evenings. It's not cathartic and soothing like gardening. But most importantly, it's not cyclical. Good economy, bad economy, the bugs just don't care.

The newest name in this part of the portfolio is another one that might surprise you. It's a US auto parts company called O'Reilly Automotive Inc (NASDAQ:ORLY). Officially, it's designated a consumer discretionary stock, but in reality, 80% of demand is needs based.

Most demand for car repair is mandatory, and that's a very resilient order flow-type business. This is one of the rare retailers that benefits from tariffs because of its slow-turning inventory. Auto parts stores have to carry a lot of inventory on behalf of their customers as availability is key.

All that inventory was purchased pre-tariff. Tariffs come in, prices increase across the board, and they get a margin uplift from the pre-tariff cost of goods sold. In a tricky economy, consumers hold on to their vehicles for longer. There are 280 million cars on the road in the US alone that are getting older and need repair. Electric vehicles (EVs) are just 1% of the mix, and even Amazon can't move fast enough to get car parts to mechanics and garages within hours.

From a single store in 1957, now with over 6,000, that will get us firing on all cylinders.

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Kyle Caldwell: As you outlined earlier, this weatherproof part of the portfolio acts as a defensive buffer when stock markets become more volatile. Of course, earlier this year, we did see stock markets become more volatile in response to uncertainty over US President Donald Trump's tariff policies. So, how did these weatherproof stocks hold up during that period?

James Thomson: Exactly as advertised. The market was down almost 5% in Q1 around the the Trump tariffs and The Department of Government Efficiency (DOGE), but the weatherproof names were up or flat over the period, and that meant my fund was only down half as much as the average.

So, the weatherproofing is there to provide some protection, not total protection, but smooth the ride. Our top performers during that period were Rollins, a US and German telco operator that'll card a decade of double-digit profit growth, and a US garbage collection business.

In the US, you pay directly for your bins to be emptied. So, I'd love to talk to you about the solid waste industry, recycling commodity prices, landfill, pricing that doesn't change whether your bin is full or three-quarters full, but now is probably not the time. It is one of the most recession-resistant industries, as most homes or businesses rarely cancel their garbage collection.

Kyle Caldwell: And during that period in which there was a notable pick-up in stock market volatility, how did you approach the rest of the portfolio, the 75% to 80%? Did you use that as an opportunity to top up existing positions and potentially introduce some new names as both share prices and valuations fell in tandem?

James Thomson:When you're in the middle of a stock market correction triggered by some unprecedented and economically destructive events, it's hard to see when the off-ramp will come.

The primary cause of the stock market volatility was, as you say, the Trump tariffs that were escalating, inflationary, mutually destructive. Recession odds increased to about 50% in April, and bearish investor sentiment hit the third-highest of all time.

But markets turn when the primary issue that the market is worried about stops getting worse. It doesn't even get better, it just stops getting worse. I think that point was 8 April when Trump stopped jawboning tariff escalation and showed some sensitivity to rates and equity markets.

But these points are pretty difficult to identify in the moment, so we'd been buying both before and after this inflection point. We bought three new holdings this year during the turmoil, O'Reilly, that auto parts company being one of them. We bought a longstanding and broadly diversified industrial business that will benefit from a resurgent industrial capital spending cycle. And we bought a technology e-commerce platform business that's been the best performer, up about 30% since we bought it a few months ago.

Kyle Caldwell: The fund has for many years had a large weighting to the US. I say large, it's in line with the MSCI World Index, which is around 70%.

Could you explain why you're continuing to back the US, particularly when there does seem to be a growing chorus of investors that are calling an end to US exceptionalism?

James Thomson:I don't think this is the end of US exceptionalism, given the extraordinary adaptability and resilience of US business. I believe they're stronger than any president. Yes, I have 70% of my fund invested in US equities. I've just bought three new American stocks, and my watch list is filled with more.

In my view, the US remains the home of innovation, adaptability, repeatable and mission-critical growth. It outperforms on tax, business freedom, lower government spending, greater employment flexibility, and a hunger to innovate. There's higher R&D spending and double the venture capital spending as a per cent of GDP. I think that's why the US has $6 trillion companies and Europe has none.

But you're right, many investors are calling for an end to US exceptionalism and a pivot to Europe. But I have about 25% of my fund in Europe, so there are some great companies, just not enough.

Europe tends to be dominated by old economy, order-driven, economically sensitive, industrial manufacturing and auto-related companies. They rely on the goodwill of neighbours and customers like the United States and China.

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Kyle Caldwell: In terms of how your US exposure differs from the broader global index, could you summarise how it is different and which particular sectors or types of industries you are backing more than the index?

James Thomson: Yeah. My US exposure and my total fund exposure does differ from the index. Fund analysts track something called active share. Mine is over 80%, which implies high active bets and significant differences from any typical global equity index. But that doesn't mean that I'm not balanced or diversified.

In fact, just the opposite. Many tracker funds these days have a significant weighting up to 23% in the Magnificent Seven, for instance. Mine is below 13%. So, I think that's a sensible choice if you're worried that the market has become too concentrated and reliant on one theme. We also diverge in other areas. We don't own any oil & gas, mining, or traditional commodity stocks.

We don't own pharmaceutical companies or biotech. We don't own any banks. We don't own any utilities other than my garbage collection company, which someone decided was a utility. And we're underweight the 30% technology waiting in the index. But that's because we found some clever ways to play technology via consumer-facing businesses.

One good example would be Walmart Inc (NYSE:WMT). It's one of the most technology-enabled retailers in the United States. More than 50% of their distribution centres are automated, so automated storage and retrieval of inventory. Robotic forklifts controlled by AI and real people can improve output by three times compared to manual retrieval. In store, all the shelves have real-time digital pricing. No more paper pricing guns.

At Sam's Club [a membership warehouse club], you scan every item as you go and then just walk out. No more queuing for the checkouts and no change in shrink. When I see an ad on Walmart.com and then go in store a week later to buy that item, they can connect the dots between those two events, and that drives their 70% EBIT margin advertising business. Technology may not take your job, but someone who really knows how to harness it will.

Kyle Caldwell: You mentioned the Magnificent Seven stocks. NVIDIA Corp (NASDAQ:NVDA) is your top holding, although I'm pretty sure it's actually underweight compared to the MSCI World Index in terms of your percentage weighting. It's a very popular stock and the share prices has gone up a lot since the market started recovering from around 7 April. Could you outline your latest views on the company, and detail when you first invested in it?

James Thomson: Yes. A good example of the wild markets that we're in at the moment. In Q1, Nvidia was one of the worst-performing stocks, down over 20% in the wake of the DeepSeek breakthrough, then up about 70%, as you say, from the lows. Nvidia is one of the most compelling investment cases I've seen in my career. This is a new era in the computing cycle that usually comes around every 15 to 20 years.

Think of the mainframe era, the PC, smartphone era, and now AI. In each one of these eras, it's 10 times the size of the previous era. In these eras, one vertically integrated company, hardware, software and chips, captures over 80% of the value, and that company is almost certainly Nvidia. The integration of the ecosystem has created a wall around their dominance, and customers know that the greatest risk is underinvestment in AI. Missing out is fatal during big technology shifts.

We've owned Nvidia for over seven years, but I must also recognise that we live in a world of left-field events and that no single holding should dominate the entire portfolio. So, we need to be nimble and nuanced and not just reflect historic performance.

So, we've taken profits in our Nvidia position. In fact, we've sold 80% of the position in the last three years, but it remains the largest holding in the fund. We used the money to buy some other interesting stocks that I think are going to be tomorrow's winners, but I can't give away all my secrets.

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Kyle Caldwell: And finally, James, I appreciate I'm asking you to gaze into a crystal ball, but I was hoping you could share your outlook for the months ahead, particularly in relation to whether you think tariff concerns could re-emerge once again and cause a pick-up in stock market volatility?

James Thomson: I think the tariff climbdown has successfully avoided a recession, but volatility could easily pick up again as we approach the next deadline and Trump wants to play hardball with China, or more likely the EU.

A strong stock market emboldens Trump just as it forced him to the off-ramp in April. Markets will continue to be sensitive to policy uncertainty, and few investors are piling into equity markets with such a noisy and disruptive political climate. And yet markets are climbing the wall of worry and are likely to reach new all-time highs.

Those second-order effects, such as temporary inflation spikes and profit warnings, are likely to emerge, but the primary cause was tariffs where the downside risks are much better understood. So, not really an obvious champagne-popping moment, but remember that Trump is quick to quarrel, but even quicker to accept concessions and declare victory.

So, despite the short-term noise, we remain fully invested and focused on the significant upside from these long-term investment opportunities.

Kyle Caldwell: My thanks to James, and thank you for listening to this episode of On the Money. As mentioned in the introduction, we'll be taking a two-week break for the summer, and we will return on Thursday 4 September.

If you enjoy On the Money, please do follow the show in your podcast app and do tell your friends about it. If you get a chance, please do leave us a review or a rating in your podcast app too. We'd love to hear from you.

You can get in touch by emailing OTM@ii.co.uk. In the meantime, you can find more information and practical points on to how to get the most out of your investments on the interactive investor website. I’ll see you in a couple of weeks.

On The Money is an interactive investor (ii) podcast.