If you are an avid equity investor then obviously you would be holding on to a wide spectrum of stocks ranging from defensive to aggressive to cyclical. What exactly do we understand by defensive stocks? These are typically stocks that lend stability to your portfolio, both in terms of risk and in terms of volatility of returns. It is very hard to classify any particular sector as defensive as the definition of defensive keeps changing from time to time.
Many investors used to consider pharma stocks as defensive stocks and that was the correct line of thinking for a fairly long period of time. However, in the last couple of years, these stocks have become so volatile due to global demand and regulatory factors, that they are no longer considered to be defensive stocks. Similarly, PSU banks were considered to be defensive stocks as they had the backing of the government and good dividend yields. It was a safe sector to park your money and you would end up profitable over a period of time with little concomitant risk. With the rising spate of NPAs, that is no longer the case and PSU banks have become high-risk stocks. So is there a model wherein we can identify whether it is the right time to invest in defensive stocks? Here are 4 key pointers..
Are P/E valuations of the market stretched?
Here we are referring to the index P/E ratios. While there are no hard and fast cut-offs for the P/E ratio, in India the markets tend to become expensive when the trailing P/E ratio goes above the 25 mark. That is the time to start shifting an increasing share of your equity portfolio into defensive stocks. Just go back to early 2015 when the Nifty had managed to cross the 9000 mark for the first time. However, over the next 1 year valuation concerns took the Nifty sharply lower to the 6800 levels. But during this entire period the defensive stocks like FMCG, pharma and private banks performed exceedingly well. Defensive stocks logically perform better on a relative basis when valuations are stretched in the market.
Are these defensive stocks brand-heavy or brand-light?
When you select defensive stocks within the overall defensive universe, it is very essential to ask a basic question on the brand-heaviness of the company. Companies with strong established brands are able to leverage their brands to maintain higher levels of ROE and therefore sustain higher valuations compared to other sectors. For example, FMCG names like Colgate, Britannia and Asian Paints are capable of leveraging their brands as much as their business models. It is always advisable to prefer defensive stocks with a strong brand impact as that makes the difference in difficult times.
Is it correlated to the level of economic activity?
Defensive stocks typically do very well when they are not exactly correlated to the level for economic activity. For example, an FMCG company that manufactures soaps and detergents is not going to get impacted by a 1% fall in growth. However, sectors like metals and capital goods will take a big hit due to this fact. Private Banks have included a large share of retail business in their portfolio and that has made them more defensive compared to the PSU banks. At the end of the day, every business is related to some extent to the level of economic activity. But the kind of value destruction that we saw in an L&T or BHEL when the capital cycle turned downwards in 2011, you will never get to see in case of defensive stocks.
Whether growth and ROE can still sustain valuations
Defensive stocks can remain defensive as long as their growth and ROE can be sustained. One of the big advantages of private banks and FMCG in India has been that they have managed to sustain their growth and their ROEs. As a result, both these sectors have continued to be defensive sectors over the last few years. On the other hand, sectors like IT and pharma have seen their growth and their margins faltering. Not surprisingly, investors are not looking at them as defensive plays any longer. The beauty of defensive sectors is that despite competitive pressures and growth worries, they are able to broadly growth their profits and ROEs, which is what makes them defensive in the first place.
Finally, it is very important to understand an important aspect pertaining to defensive stocks. You need to adopt a bottom-up approach when it comes to defensive stocks. You cannot add defensive stocks to your portfolio on a broad sectoral basis. Adding any private bank or any FMCG company may not be the answer. You need to ask questions on whether the company has a sustainable brand, whether the ROE is sustainable and whether the growth can be sustained in trying circumstances. That is what makes a good defensive investing strategy.