Is there value to be found in defensive/income stocks?

Looking at the current global circumstances, should investors be considering defensive stocks?

Article updated: 23 April 2018 12:00pm Author: Ian Forrest

The market has been fairly volatile in recent months due to a number of factors. The threat of a potential trade war between the US and China is one, the fact that the Brexit talks are about to enter their most crucial phase, negotiating the future trading relationship between the UK and the EU, is another. Big investors dislike uncertainty and the second factor is one reason they may be cool towards UK stocks, especially those with significant trade with the EU, until there is clarity on the trading position beyond 2020.

Another important factor has already had an impact. The US Federal Reserve has started raising interest rates and is likely to increase them several more times this year. The Bank of England, as it often does, followed suit although it is unlikely to launch into a series of further rises.

The consequence of the general rise in interest rates and the removal of central bank support through bond purchases, is that bond yields are expected to rise. That, in turn, can cause some investors to switch out of shares and into bonds, which are lower risk.

It has been noticeable that a number of the larger and higher yielding stocks in the market have been underperforming in recent months. Many of these are what are known as defensive stocks, but what exactly does that mean? Firstly, it’s important to clarify that “defensive” does not mean companies in the defence sector such as BAE Systems.

The term defensive refers to the nature of the business rather than the sector it serves. In other words, these are companies whose revenues don’t tend to change much regardless of how the economy is performing because demand for their products and services tends to be fairly steady. Businesses offering telecoms services or selling everyday essential items from household cleaning products to common pharmaceuticals to catering fall into this category.

The ultimate, of course, are utilities such as energy and water providers where prices are heavily regulated and the highly predictable income over future years means the companies can make promises about dividend payments. The reliable level of cash flow from defensive stocks increases the degree of certainty about payments and is similar to interest payments on corporate bonds, which has led to the term “bond proxy” describing these companies.

So has the fall in some defensive stocks recently created some opportunities?

The first thing to say is that trying to time share purchases exactly at the bottom of the market is virtually impossible. The best that most of us can do is to try to buy when stocks looked good value and try to sell when they look overvalued.

As mentioned previously, many defensive stocks offer good dividends and so appeal to income-seeking investors who are looking to hold for a reasonable period of time.

One of those is energy distribution group National Grid whose shares hit a 5-year low in recent weeks. Even after a slight rally the dividend yield is still an attractive 5.4% and the company is committed to increasing dividends at least in line with inflation.

Regulator Ofgem has announced a tougher regulatory framework that will lower profits from 2021, and the utilities sector generally has come under more political pressure over the past year, but National Grid is increasing its focus on its US business and remains a buy for low to medium risk investors geared to an income portfolio.

Another stock which has recently dipped to near the bottom of its trading range is mobile giant Vodafone. For around five years the stock has been in a fairly narrow 190p-230p range but it dropped to near the bottom of that after announcing in February that it was in discussions about acquiring assets in Germany from US media group Liberty Global.

While emerging markets have provided most of Vodafone’s growth in recent years the potential move in Germany would make sense given that it has been one of its best European markets in recent times. There was more good news in April for the company’s 5G high speed mobile internet plans as it was successful in an auction of spectrum by Ofcom. Free cash flow, a key factor is enabling a company to pay sustainable dividends, has been recovering steadily and is expected to hit Euro5bn this year. With the dividend yield standing at an attractive 6.3% the shares remain a buy for lower risk investors seeking income.

Pharmaceuticals is another relatively defensive business, especially for the larger groups which have many different brands spread across a variety of sectors and regions. One of the largest companies in the sector, GlaxoSmithKline, has underperformed the market over the past year due to uncertainty about its future dividends. However, there was good news on this front in March as the company announced its intention to buy the minority stake in its consumer healthcare business owned by Swiss group Novartis.

Glaxo also said it was not planning to bid for Pfizer’s consumer healthcare division, all of which increases confidence in its balance sheet and potential to retain, or even raise, dividends further. The yield is a tempting 5.8% and earnings should benefit from the launch of new products and increasing exposure to emerging markets. We retain our buy recommendation for lower risk investors primarily seeking income.

Finally, a fall in the share price of a defensive business is not always a good sign. Centrica, the owner of British Gas, is a good example of this. The shares have fallen 35% over the past year, prompting an apology from the CEO, due to a range of factors including increased competition leading to customers leaving, mild weather reducing demand and a greater focus by politicians on energy prices.

While the company maintained the dividend in February, and said it intended to maintain it, the yield of 8% suggests that the market has some doubts as to whether this is achievable. For us it is no better than a hold for medium to high risk income seekers.

So while defensive stocks are generally lower risk and provide some stability in a portfolio with reasonable dividends, investors still need to be careful when choosing them.

All information given including prices, yields and our opinion is correct at the time of publication. Our opinions on investments can change at any time and for our latest view please go to www.share.com. To understand how our Investment research team arrive at their views please read our Investment Research Policy.

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Ian Forrest

Investment Research Analyst

Ian’s background in investments, financial journalism and research has seen him advising private investors on equities and helping to manage portfolios. His qualifications include the Certificate in Financial Planning and the Chartered Institute for Securities & Investment’s Investment Advice Diploma.