Defense Wins Championships!

By Deron T. McCoy, CFA®, CFP®, CAIA®
Chief Investment Officer

It’s a tried and true maxim of sports. But one that has clear parallels in the investing arena as well. Over extended periods of time, some of the best performing portfolios are those that maintain a defensive element to help them weather the most turbulent of times. But exactly what types of investments qualify as defensive? Unfortunately, there’s no definitive black or white answers – only shades of gray depending on your personal definition of “defensive.”

At one extreme, there’s cash (although an argument can be made as to whether cash is actually an investment). Many view holding cash as a relatively no risk strategy. In an era of zero-interest-rate monetary policy, cash may not lose value in the normal sense, but it won’t grow either. Over time, the “real value” of cash gradually loses its purchasing power as inflation quietly erodes its worth; ensuring a negative real return.

With that in mind, some investors opt to move out on the risk spectrum into government bonds for their defensive holdings. Although the daily value of these slightly riskier investments may fluctuate, over the long haul they seek to capture some positive real returns after adjusting for inflation. In the current low interest-rate environment, however, even a 30-year Treasury bond probably won’t generate enough of an annualized yield to maturity (less than 1.50%) to keep pace with inflation over the next three decades – especially when you factor in annual taxes.

Others reach even further on the risk continuum and invest in corporate bonds as a defensive play. After adjusting for taxes and inflation, corporate bond investors can typically expect positive returns (with some yields in the mid-single digits). But these investments are not without some element of risk. Although a great many corporations will thrive in the decade ahead, some companies may be forced into bankruptcy; and it is here where the corporate bond investor can lose money.

To some investors, even those mid-single-digit returns of corporate bonds aren’t worth the relative risk compared to the outsized returns they could potentially earn via the equity of those companies. Of course, taken as a whole, stocks are not defensive investments, but there are certain subsets of stocks which can be significantly more defensive than others. One classic example of a defensive sector are stocks tied to everyday consumables. In a recession, people may cut back their spending on nonessential entertainment items (classified as consumer discretionary stocks) but society rarely turns off the lights and heat (i.e., utilities) or stops brushing their teeth and buying food (i.e., consumer staples). These types of investments, therefore, tend to hold up better when the overall market turns bearish.

All this begs one final question: “When should I buy these defensive stocks, and how much should I own?” Conventional wisdom says that like insurance, the time to buy these defensive stocks is before you need them. The logic holds that by the time a recession is well-known, the damage (and benefit associated with rotating to defensive stocks) has already played out in the marketplace.

But one of the principal reasons why the vast majority of investors fail to keep pace with the S&P 500® is because their portfolios rarely resemble the actual index. If you analyze the 500 underlying companies, you’ll find that 20-30% of the stocks have defensive characteristics – they either outright reside in the Utilities or Consumer Staples sectors of the economy, or they have similar recurring revenue streams but reside in different sectors (e.g., a maker of medical devices and Band-Aids in the Healthcare sector or mission-critical landlords in the Real Estate sector). In fact, you can find these stable and recurring revenue companies in nearly every corner of the S&P 500.

In the world of sports, it’s often acknowledged that the best defense is a good offense. But when it comes to investing, the reverse may be more appropriate – the best offense is a good defense. And it’s never too late to strengthen your defenses.

 

Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. The information contained herein reflects the firm’s views and is subject to change at any time without notice. Views expressed in this newsletter may not reflect the views of Royal Alliance Associates Inc. Indexes cannot be invested in directly, are unmanaged and do not incur management fees, costs and expenses. Past performance is not a guarantee of future results. Securities offered through Royal Alliance Associates, Inc. member FINRA/SIPC. Investment advisory services offered through SEIA, LLC, 2121 Avenue of the Stars, Suite 1600, Los Angeles, CA 90067, (310) 712-2323. Royal Alliance Associates, Inc. is separately owned and other entities and/or marketing names, products or services referenced here are independent of Royal Alliance Associates, Inc.

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