What’s happened to defensive stocks?

For decades defensive stocks, such as healthcare, consumer staples and utilities, were seen as a safe haven in volatile markets because demand for their products and services seemed uncorrelated with the business cycle. Such sectors might therefore be expected to perform relatively well in a weak market, growing their earnings over time but in a steady, modest way.

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However traditional ideas around defensive stock sectors are breaking down, partly because these industries face very different challenges compared with a few years ago, and partly because higher bond yields divert capital away from equities, especially defensive stocks, which offer lower growth potential but are seen as safer investments. 

Covid has been disruptive

“Since Covid, the world has experienced a continuous string of events that have disrupted businesses on a scale not seen since the financial crisis,” says Martin Frandsen, a portfolio manager at Principal Asset Management.  

He adds: “While the stock market on an aggregate basis has fared well led by large tech companies, most sectors have seen disruptions in the realm of geopolitical conflicts and policy uncertainty. In some cases, this has meant businesses that under normal circumstances are highly stable and predictable, have faced disruptions that call into question their defensive characteristics.”

Take consumer staples, classified as essential goods that consumers purchase regularly, such as food, household products, and personal care items. Many such companies have been losing their pricing power and sales have been eviscerated, most obviously sales of soap and toothpaste which were sharply hit by Covid (a 48% drop in sales among British shoppers in the first half of 2023).

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Since then, rising levels of inflation have led consumers to cut back on essential items. Sanjiv Tumkur, head of equity research at Rathbones, points out that “consumer staples have suffered lower volume growth as consumers have reacted to them raising their prices to defend margins when cost inflation surged after the Russian invasion of Ukraine”.

He continues: “This led to growth in demand for own-label offerings from supermarkets such as Walmart and Tesco. At the same time, there is increased competition from start-ups deftly using social media to gain product awareness. The increased prevalence of GLP-1 weight-loss drugs has also led to questions about long-term demand for many food and beverage categories, amplifying concern about ultra-processed foods.”

Utilities face ‘inflection point’

Utilities is another classic defensive sector which, as a recent Goldman Sachs report points out, is “undergoing a critical inflection point, driven by regulatory tailwinds for clean energy, valuation resets tied to capital discipline, and the emergence of small modular reactors (SMRs) as a transformative technology”.  

The UK government is actively promoting the installation of small nuclear fission reactors by the early 2030s, with Rolls-Royce Holdings (LSE:RR.) selected as preferred bidder. However, while nuclear revival and SMRs are strategic growth areas, execution risks remain, and meanwhile Trump is proposing a roll-back of incentives for clean energy projects.

Telecoms also face the need for massive capital investment, to update their networks to handle growing volumes of data, while healthcare companies face uncertainty around drug pricing reform and research funding under the Trump administration.

In all cases, what’s changed is that sources of risk are more varied today than they were in the period between the financial crisis and the pandemic.

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“Back then, a slowdown in growth was the chief worry for investors,” says Mario Baronci, multi-asset portfolio manager, Fidelity International.  

He further points out: “When it looked like economic prospects were turning sour, it made sense to turn to sectors that could carry on churning out reliable earnings even in a recession – utilities, healthcare, and consumer staples among others. But we are now living in an environment where risks can appear from several different angles. Investors still need to think about growth risks but also those stemming from inflation, conflicts, the recent geopolitical upheavals particularly concerning trade policy, AI disruption, and the concentration of global equity indices in US tech.”

The move up in bond yields over the last few years has also been a drag on the defensive sectors versus cyclicals. Higher bond yields has meant traditionally defensive equities have less appeal to investors. “While there have been many issues with deterioration in some defensive companies’ earnings, we think bond yields are likely playing a bigger part in the underperformance of defensive relative to the cyclicals since 2022,” says Jason Da Silva, director of global investment strategy, at Arbuthnot Latham.

Defence sector revival

Not all defensive industries are struggling, however. Take the defence sector, which is enjoying a revival thanks to increased European defence spending prompted by changing US priorities and Japan’s decision to regain its defence capabilities. Arguably of course, defence should never have been classified as defensive as it depends heavily on government spending and geopolitical instability, but it currently offers an attractive combination of steady cash-flow generation and low uncertainty about future growth.

While most of the fast growth is in some smaller companies offering specific capabilities, larger defence players such as BAE Systems (LSE:BA.) and Thales (EURONEXT:HO), will also benefit from their strategically important offerings in air and missile defence, electronic warfare, unmanned systems and command and control systems.

For investors, the ease with which they can forecast a company’s earnings is crucial. “The intrinsic value of a company with a high degree of earnings predictability is likely to remain stable through the ups and downs of an economic cycle,” says Bertrand Cliquet, a infrastructure portfolio manager at Lazard. He adds: “Natural monopolies, economies of scale, network effects, intellectual property (patents and brands), and high switching costs all make for easier-to-forecast earnings.”

However, even the most predictable earnings are no guarantee of capital preservation if investors pay too much at the outset. The sharp fall in renewable energy company prices in 2023 demonstrates the dangers of overpaying for defensive stocks, even if those companies generate predicted earnings.

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As Ian Lance, co-manager of Temple Bar Ord (LSE:TMPL) investment trust, points out:  “A company that grows it earnings per share at 5% for five years but de-rates from a price earnings multiple of 25x to 14x will result in a loss of a third of your original investment. Investors have learned this the hard way in stocks like Nike Inc Class B (NYSE:NKE), which is 60% lower than its 2022 high, and Novo Nordisk AS ADR (NYSE:NVO) which has halved in a year.”

As always, the Holy Grail is pricing power, strong moats, and unique products tied to long-term secular trends. Such companies “are often found at the intersection of technology, healthcare, and consumer - such as software serving non-discretionary sectors like healthcare or essential consumer goods companies, which can offer both predictability and structural growth beyond what traditional defensives now provide”, says Carlos Hardenberg, portfolio manager of Mobius Investment Trust Ord (LSE:MMIT) investment trust.

Lance notes some stocks previously shunned as being too cyclical are now displaying defensive characteristics. “Banks like NatWest Group (LSE:NWG) are currently making returns on equity that many consumer companies can only dream of and are also producing steady earnings growth. NatWest, for instance, made a return on equity of 18% last year and its earnings per share is forecast to grow from 50p in 2024 to 74p in 2027.” Despite this, Lance notes that it trades on a low PE ratio, which is currently 9x.

Quasi-utility services

A number of companies have evolved to deliver ‘must-have’ quasi-utility services to their customers, demand for which should be relatively impervious to economic shocks. Tech giants such as Amazon.com Inc (NASDAQ:AMZN), Microsoft Corp (NASDAQ:MSFT) and Alphabet Inc Class A (NASDAQ:GOOGL) have cloud businesses providing hosting services which are business-critical for customers and have utility-like characteristics.

Tumkur says the “software sector, which a decade or two ago relied on lumpy software licence sales, has now shifted to a ‘software as a service’ model, whereby customers in effect rent software from the likes of Microsoft, Salesforce Inc (NYSE:CRM), Intuit Inc (NASDAQ:INTU) and Adobe Inc (NASDAQ:ADBE) for a monthly fee; where this software is critical to the customer, this creates a recurring and predictable revenue stream. However, advances in AI and particularly generative AI have raised concerns that these may create opportunities for new players to swoop in and capture business if incumbents are not quick to harness it themselves.”

Chris Elliott, portfolio manager of IFSL Evenlode Global Equity fund, highlights RELX (LSE:REL), which provides data and software to professionals in industries with low correlation to the business cycle such as law, academia, and insurance. “Their clients see these services as mission critical, despite their relatively low cost, and demand is very constant from one year to the next. This creates high incentives not to switch, excellent pricing power, and steady revenue and cash flow.”

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Music and entertainment content for consumers should also weather economic gloom, as consumers prioritise these low monthly cost subscription services as they spend more time at home to save money.

“Non-life insurance companies such as Sampo or Admiral Group (LSE:ADM) or insurance brokers such as Marsh & McLennan Companies Inc (NYSE:MMC) have also typically proven defensive as home and motor insurance do not tend to fall during downturns,” says Tumkur. “A counter-cyclical corner in financials is exchanges such as Euronext NV (EURONEXT:ENX) for European stocks and CME Group Inc Class A (NASDAQ:CME) (Chicago Mercantile Exchange) for derivatives, as trading volumes spike during economic turmoil.”

Commodities are another defensive solution. Fidelity’s multi-asset portfolios currently hold long-dated government bonds should growth slow, and commodities should inflation re-ignite. “We have an allocation to gold as a safe haven in the event of conflict escalation and positions in several uncorrelated sources of return such as long-short equity strategies and CO2 emissions,” says Baronci.

Premier Miton is also looking to commodities to provide defensiveness rather than defensive equities which might suffer from inflationary spikes. “If markets suffer setbacks, we expect this to be less as a consequence of economic slowdown, where traditional defensives would have performed well, and more from either external geopolitical shocks or periods of higher inflation,” says David Jane, fund manager of Premier Miton Cautious Monthly Income fund.

“In such an environment, gold or commodities, such as energy, will be the more likely places to hide.  This can be seen in the setback in 2022 where higher interest rates sent the market lower, and energy was one of the best sectors to hide [in]. It might even be the case that another traditionally cyclical area, such as materials (metals and miners), performs well in a weak equity market, again because of inflation.”