Another day, another set of headlines about the absolute bloodbath in technology stocks. At the time of writing, the latest news is about Claude Mythos, Anthropic’s new AI model that is being described as a “reckoning” for the cybersecurity world. Palantir, CrowdStrike, Palo Alto Networks and other important names in this sector all dropped sharply on the news.
The cybersecurity industry is now feeling the pain that the software as a service (SaaS) players have been experiencing for months. Salesforce is 45% off its 52-week high — and dropping. Adobe is slightly worse, if you can believe it.
These were the darlings of the technology industry in the run-up to the pandemic, with investors paying high multiples for supposedly bulletproof cash flows. Fast forward to today and you’ll find a market that is terrified.
The fear is that the economics of SaaS firms have been structurally diminished. It’s not about whether these companies will survive, or even continue to attract large customers; it’s about how AI is bringing down the cost of software.
This is a good reminder that certain industries should never be thought of as defensive, no matter how good the underlying companies appear to be.
This begs the question: how do you identify defensive stocks? And should you even care?
Why bother?
This question isn’t as ridiculous as it sounds. After all, isn’t taking risk the whole point of adding equity exposure to a portfolio? If you’re looking to play it safe, wouldn’t you just put your money into money market accounts?
It’s not quite that simple, as least not for most investors.
The vast majority of countries don’t offer investors real returns (returns in excess of inflation) for putting their money in a “100% safe” money market account. South Africa is a rare exception, with the South African Reserve Bank maintaining tight economic policies. We have structurally high interest rates and a low inflation target.
But even in South Africa, being exposed to money market accounts means that you’re only beating real-world inflation (not official CPI, which is a somewhat esoteric concept) by a small margin.
Your exposure in that situation also sits in rands, which only recently started to look like a good idea. A sensible long-term portfolio would look for some exposure beyond our market, which is where risk-free real returns become almost impossible to find.
If you move further along the risk curve, but without dipping your toes into equities, you could consider fixed income funds that invest in bonds. Don’t be fooled by the term “fixed income”: you’re taking risk here, particularly if you dabble in long duration bonds; it’s just a different type of risk.
There’s a spectrum of risk-taking opportunities out there. It’s important to understand this fundamental concept when talking about defensive stocks.
The next stop on the risk curve after bonds would typically be property funds, which investors view as a hybrid of fixed income and equity. Akin to inflation-linked bonds, the real estate investment trusts (Reits) pay a distribution that should increase every year.
The word “should” isn’t the same as “will” — a lesson learnt the hard way during the pandemic — but at least there is compensation for the risk being taken in the form of potentially higher returns in Reits than in bonds.
For many portfolios, adding a strong helping of Reits adds a defensive element and an income underpin. In tax-free savings accounts in South Africa, there’s the added benefit of getting the juicy distributions without paying tax on them.
In my opinion, the “defensive” stocks in the market sit further along the risk curve than Reits. This is why I tend to favour the Reits, as their defensive characteristics are underrated by the market.
Back to the original question: should you even bother with defensive stocks?
This is a murky and subjective area, which is why the debate around defensive vs riskier stocks (such as cyclicals) isn’t always straightforward. Ultimately, the decision to invest in these stocks comes down to personal preference and the optimal risk-reward mix you are seeking. There’s technically no right or wrong answer here, nor is there a one-size-fits-all approach.
Assuming you’ve done the right thing and spoken to an adviser, how would you go about identifying the defensive stocks that you want to own?
Well, there is a wrong answer: a mismatch between your risk tolerance and the shape of your portfolio. That’s why financial advisers are important. But assuming you’ve done the right thing and spoken to an adviser, how would you go about identifying the defensive stocks that you want to own?
Boring businesses can be great businesses
Typically, a company is seen as defensive when it offers cash flows that are reasonably dependable regardless of whatever macroeconomic cycle we are in. You won’t find stocks that are immune to what’s going on out there, but you can find businesses that focus on products such as energy, health care or core industrial services.
Regardless of the economic situation, you need electricity for your home. Your waste needs to be collected. When you’re sick, you need a doctor — or a hospital.
The overlap here with typical public sector services is no accident. Private sector companies providing government-like services are among the most successful defensive stocks in the market. They are thin on the ground in South Africa though, as we aren’t big on privatisation here.
In the US, it’s a different story. And with interest rates in that market offering far less exciting risk-free or low-risk returns for investors, the market tends to pay high multiples for truly defensive stocks.
A great example is Waste Management ($WM), a North American business that does what it says on the tin: it collects, transfers, recycles and disposes of waste. This means long-term contracts with municipalities and businesses, creating revenue visibility and noncyclical returns.
The underlying infrastructure required to provide this service is difficult to replicate, creating a moat for this business that is much wider than anything Claude can disrupt.
Jokes aside, in this AI era it’s highly debatable whether any technology company has a moat anymore. Physical assets have suddenly become far more dependable — even if those assets are as unsexy as landfills and waste transfer stations.
A defensive model doesn’t mean a business that isn’t capable of generating strong returns. Waste Management’s share price has achieved a 10-year compound annual growth rate (CAGR) of an exceptional 15.1% — and yes, that’s in dollars. The return over the past 12 months is only 3.9%, but it’s been a rather wild 12 months to say the least.
On a p:e of about 35, the market prices Waste Management like what it is: an extremely high-quality company with low underlying risk (by equity standards).
On the utilities side, a good example in the US is NextEra Energy, a stock I have in my portfolio. Headquartered in Florida and with its roots firmly in the Florida Power & Light utility, NextEra has expanded well beyond its initial geographical region. It has invested heavily in renewable energy projects in North America, supported by long-term power purchase agreements.
For Claude to be doing such a great job of disrupting software and now cybersecurity firms, there need to be powerful data centres that consume breathtaking amounts of energy. This is where a utility can unlock underlying earnings growth in the form of increased energy demand and more efficient technology to supply that energy.
NextEra has achieved a 10-year share price CAGR of 12.5%, a solid result. It’s incredible to see how much of this has come in the past 12 months though, with a return of nearly 40% thanks to expectations around energy needs in North America.
Even “boring” businesses can experience heightened levels of volatility. This is exactly why the term “defensive” can be so misleading. Can we really describe a stock with a 40% return in a single year as being defensive?
Be very careful in the consumer space
Perhaps the worst abuse of the word defensive takes place in the consumer staples sector. Names such as Coca-Cola will often come up, or Nestlé. Unilever, Procter & Gamble and even Walmart will frequently be referenced as countercyclical choices.
Here’s the underlying problem: in all these cases, consumers always have a choice. Sure, they need to wash their hair, but does it need to be with a branded product? They need to drink something, but it could be water instead of Coke. And when they shop at Walmart, the outcome for shareholders is very different if the trolley is full of rice and tinned foods instead of chocolates and appliances.
The rapid adoption of GLP-1 drugs such as Ozempic showed the world that these consumer names aren’t immune to trouble. You can think of GLP-1 as the Claude of the FMCG market, driving a structural decrease in demand for what can best be described as junk food. When consumers are paying for appetite suppressants instead of chips, PepsiCo shareholders are having a bad time.
PepsiCo shareholders can only lament their 10-year share price CAGR of 4.2%. The Coca-Cola Co is hardly any better, with a CAGR of 5.3%. Procter & Gamble sits at 5.9%, while Unilever is even worse at just 1.7% growth per year.
Walmart has been a star performer, with a CAGR of 19.1%. But that’s not because it is a defensive stock at heart. No — this performance is thanks to the growth in e-commerce and Walmart’s success in taking the fight to Amazon.
There are some excellent defensive stocks out there that offer wide moats, reliable cash flows and strong protection against inflation. But the FMCG product space, with exposure to everything from consumer tastes through to raw material costs, isn’t where you’ll find them.
Walmart, Waste Management and NextEra Energy all have one thing in common: they are in the right place in the value chain. Perhaps defensive stocks have less to do with market cycles and more to do with Michael Porter’s good ol’ five forces — new entrants, supplier power, buyer power, substitutes and rivalry?
