10 shares for investors wanting defensive options

It’s anyone’s guess how inflation and possible recession will play out this year. For risk-wary investors, taking a defensive approach to equities seems sensible. But what should you look for?

Early in 2023, analysts and asset allocators were cautious, bordering on bearish, when it came to predicting what was in store for shares this year.

After market turbulence in 2022, the big questions were about how quickly central banks could tame inflation, and what impact rising interest rates would have on the economy.

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With the first quarter of the year now over, we’re no clearer on the answers to either of those questions. That is because the most influential barometers of what markets really think have been sending mixed messages.

One of them is the stock market itself. Confidence in shares hinges on the outlook for company earnings. And in the early weeks of this year, shares got off to a very strong start. At the very least, it was a signal that equity investors felt that any near-term recession would be shallow. Some thought we’d ducked the risk altogether.

The second barometer is the bond market. This is a closely-watched predictor of future inflation and interest rates. Variations in bond yields over different time horizons can tell you a lot about how investors see the strength of the economy both now and in the future. On that front, bond markets have been pricing-in a fall in interest rates as early as the end of this year. That seems quite optimistic.

But are things really as rosy as the stock market and the bond market imply? Some think not.

Pressure in parts of the banking system - notably with the collapse of Silicon Valley Bank in March - have been partly blamed on the rapid rise in interest rates. While some fault almost certainly lies with SVB itself, the episode has been a warning to central bankers that raising rates quickly risks breaking things. They may now feel more cautious about hiking rates much further, even if inflation stays sticky.

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The net result of all these moving parts is that controlling inflation and protecting the economy looks even trickier than it did at the start of the year. Many forecasts now expect a recession. For investors, it’s time to think more defensively about shares that are better at withstanding the dragging effects of high inflation and an economic downturn.

A defensive checklist

Here are some ideas for what a more defensive investment strategy might include:

#1 Defensive industries - Industries that are insulated from domestic economics and consumer spending can be more resilient in a recession. Companies in sectors such as consumer defensives (including supermarkets, beverages and tobacco), healthcare and utilities have customers that tend to buy whatever the economic weather. They were among the strongest performers in 2022 and could be again if confidence starts to wobble.

#2 Lower volatility - Company shares with a history of low volatility (standard deviation) and low sensitivity to movements in the wider market (beta), tend to be associated with being more defensive and predictable. These shares have been shown to be solid in both bull and bear markets and less susceptible to the vagaries of speculative investors. Their predictability can be welcome if prices become erratic.

#3 Good quality profitability - Companies with wide profit margins, and a good track record of generating strong returns from the cash they invest to grow, can be a safer option in a recession. Solid profitability gives them more breathing room and makes them less dependent on debt, where rising interest rates can cause problems. These types of shares can attract premium valuations in uncertain times, but their quality can make them worth it.

With these ideas in mind, let’s take a look at companies that have some of these defensive traits. In this case I have applied a minimum market cap rule of £500 million.

Source: SharePad

This list is sorted based on the strength of company average operating margins over five years. Solid, double-digit margins can be a pointer to strong profitability and pricing power. It’s an element of defence if there is a recession.

Margins are usually best used to compare companies in the same industries. In this table you can see that healthcare firms generally have stronger margins than consumer staples. That said, beverage giant Diageo (LSE:DGE) beats all of them on this measure with an average operating margin of 30.6%. GSK (LSE:GSK) is the top healthcare share, with a margin of 27.5%. 

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Both those top shares also have strong average returns on capital employed (ROCE), which is a measure of how efficient firms are at driving a profit. Unilever (LSE:ULVR) takes the top spot for the consumer stocks, with a ROCE of 20%, while Hikma Pharmaceuticals (LSE:HIK) takes it for the healthcare shares, with 15.7%.

This table also includes beta, which is a measure of how sensitive a company’s shares are to the wider market over time (five years in this example). It isn’t a pure measure of risk, but it does give you a hint of how each share moves in relation to the market. The market beta is ‘1’, so anything with a beta of less than that is less sensitive than the market. Unilever and Dechra Pharmaceuticals (LSE:DPH) have the lowest beta in the table, but they are all below ‘1’.

Belt up for a bumpy ride

High and rising inflation has been one of the most influential themes in Western stock markets over the past couple of years. Right now, the focus is on what the end of this cycle will look like and when it will happen. For those feeling bullish, it could present good value opportunities that you only get when markets lose confidence.

But for those investors seeking to position their portfolios more defensively, a focus on higher-quality firms in more defensive industries that are less sensitive to the wider market could be worth exploring. There is no guarantee of protection, and careful research is essential. But in the search for better protection, defensive options could be the way to go.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.