How To Invest In Defensive Stocks

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Defensive Stocks In Times of Political Turbulence

One of the first things investors learn about markets is to separate cyclical and defensive sectors. Cyclical stocks, they are told, behave like economic cycles. Up they go when the business cycle swings up. Down they crash on recessions. Meanwhile, defensive stocks will not go out of fashion. Their earnings are stable (sort of) throughout the entire economic cycle. Hence they will probably underperform during rallies and hold up better during slowdowns. Or, do they?

In the UK, many so-called defensive stocks have seen their share prices obliterated over the past few years. And UK’s economic performance wasn’t bad in light of the political upheaval, namely, Brexit. So this begs the question: Are UK defensive sectors about to see a less bearish re-rating as UK approaches Brexit?

What Happened To UK Defensive Stocks?

The UK FTSE 100 index has a few large-cap stocks in defensive sectors such as utilities, tobacco or consumer staples. A quick flick-through of their charts, however, shows tremendous damage inflicted upon their suffering shareholders. For example, BT Group (LON:BT.A) saw its share price collapsed by 60% (see charts below). The correction in British American Tobacco was far steeper than anyone had anticipated. Centrica halved during 2013-16; and nosedived another 50%.

What happened? A combination of rising business challenges, political fears (eg nationalisation), and eroding business moats. So much so that some are even questioning their viability. The Sunday Times put out an interesting article (Jul 8, 2018) entitled: ‘Death of the power dinosaurs,’ that spelled out the life and death struggles of UK’s Big Six power firms. Understandably, with the market sentiment so negative, few investors want to touch these firms.

But are these firms as ‘bad’ as they look? In other words, are the pricing of these firms overly bearish? Of course, here I am referring to defensive stocks as a whole.

Massive Sell-offs Lead To…..

Since 2014, there were two major panics in the UK stock market. The first was the massive sector sell-off in commodity-related stocks in late 2015 and early 2016. The other was the week after the Brexit referendum in June 2016. What was the common denominator in both of these cases? A major recovery!

Look at some of the large-cap commodity and energy stocks below. Since 2016, their returns have been sizzling. In late 2015, Glencore was rumoured to be under severe duress due to its large debt load. Its survival was questioned. The same issued plagued Anglo American, which saw its share price collapsed from 3,500p to below 250p during 2011-15 (see charts below).

After some restructuring and a recovery rally in commodity prices, Glencore’s share prices rallied by 5x since. Anglo American, too, saw its prices gained 6-8x in 30 months.

Don’t forget the extreme sentiment when crude oil crashed below $27 in Jan 2016. Article after article came out that articulated why the commodity ‘supercycle’ is over. Look at oil prices now – above $80!

Which Brings Us Back to UK Defensive Stocks…

Are we seeing a repeat of the crash and rally of commodity stocks in 2015? No doubt, a lot of these UK defensive stocks are mired in downtrends. Some of these trends have been going on for at least 2-3 years.

Therefore, it is likely that some of their current business models are under threat. Investors are expecting a material hit to their earnings. High yields may be a mirage as firms are squeezed for survival. However, at this rate of decline, their equity valuation are being compressed.

‘ I get what you’re saying,’ readers will opine, ‘But don’t tell me what to buy, just when.’ Of course, everyone loves to buy at the bottom. But hardly anyone can do so consistently. But there is a clue: Market panics.

When the commodity downswing ended in 2016, the whole market was in panic. Liquidation of holdings went into overdrive. The same with Brexit. Therefore, on bottom picking these defensive stocks, waiting patiently for a market correction that pushes the market sentiment into extremely bearish. Then go the other way. As John Templeton said it best: “If you want to have a better performance than the crowd, you must do things differently from the crowd.”

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