Defending with non-cyclical investing

17 June 2008

When the stockmarkets start taking a turn for the worse most fund managers have a few trusty ways of stabilising their portfolios. And with the credit crunch helping drive a slowdown in global markets, these tactics have become increasingly handy in recent months.

The most obvious safe havens from economic and stockmarket volatility are fixed interest and cash, while in the latest downturn many investors are looking to those areas of the emerging markets least affected by the global crisis, most notably China, India and Russia.

Similarly, many fund managers ramp up their exposure to blue chips, which are generally better built to withstand turbulence, or take steps to further diversify their portfolio. Elsewhere, 'shorting' - a way of making profits from falling prices - is becoming increasingly popular, with absolute and target-returns funds taking full advantage.

But a much more straightforward way of limiting the damage from volatility is to invest in companies that are unlikely to falter during harder times. These companies are known as 'non-cyclical' or 'defensive' stocks because they aren't entirely exposed to market sentiment and therefore do well regardless of what is happening in the wider economy. "Cyclical industries have been hammered in the last six months, especially financials - like banks and retailers," says Gavin Haynes, investment director at Whitechurch Securities.

When things start to look rocky, and the cost of living starts to rise, the first things we tend to cut back on are white goods and luxury items. So, when money feels tight, that plan to upgrade your car or do up the living room gets put on the back burner. Businesses are exactly the same, reining in spending on things such as office expansion, staff and new facilities.

This means that there are certain stocks that will never fare well during times of economic gloom. But, even when money is tight we still need food, water, gas and electricity - and are paying even more for them in fact - as well as those everyday household goods such as detergent, toothpaste and toilet paper. Pharmaceuticals and even tobacco also fall into this category. That's why these are known as non-cyclicals - regardless of where we are in the economic cycle, demand remains relatively constant and so the companies in those industries consequently do well.

Meeting needs

"Non-cyclical companies are those with a product that either has a monopoly type of position, such as in utilities, or meets a basic need, such as food retailers or pharmaceuticals firms," explains Randal Goldsmith, director of fund research for Standard & Poor's Fund Services.

There are other exceptions to broader market trends too, adds Goldsmith. "There are some products and services that aren't essential but are addictive, such as tobacco, which benefits from stable demand regardless of what's happening in the wider economy."

According to Julian Chillingworth, chief investment officer at investment house Rathbone, defence is an obvious area of non-cyclical growth. "Defence spending won't slow with the wider economy, so companies like BAE Systems enjoy earnings growth even in a slow environment." One trend being exploited by Rathbone as a defensive option is the long-term growth in power generation in the developing world.

Chillingworth's Income and Growth fund invests in Aggreko, for example, which, among its activities, provides power units for African mines. More than 3% of the fund, meanwhile, is invested in Vodafone.

But while it's easiest to identify stocks that meet the definition of being non-cyclical and defensive rather than funds, it's also possible to steer away from collective investments - such as unit trusts and investment trusts - that are exposed to cyclical risks.

Growth funds, for instance, are one option as they focus on stable long-term earnings growth rather than finding value in companies that they think look cheap.

Haynes points to the Liontrust First Growth fund, run by Jeremy Lang and the New Star UK Alpha, 20% of which is invested in aerospace and defence. He particularly likes the M&G UK Select fund run by Mike Felton. As of the end of March, its top holdings included BP, Vodafone, Royal Dutch Shell and GlaxoSmithKline . Haynes adds: "The M&G UK equities team has been very defensive over the last year."

Neil Woodford, who runs Invesco Perpetual's massively successful Income and High Income portfolios, has long focused on defensive stocks, too. At the start of the millennium he famously shunned the technology boom and while performance lagged in the short-term, his investors were laughing when the bubble burst.

Today, he favours pharmaceutical firms such as AstraZeneca (AZN) and GlaxoSmithKline, while telecoms, which Woodford says has good defensive characteristics, are also represented through large holdings in Vodafone and BT (BT-A). The result of Woodford's preference for defensive stocks is that while the fund has fallen in the past year, it hasn't suffered quite as much as many of its peers in the sector.

Non-cyclical investments aren't just a useful way of shoring things up when the going gets tough, however. If you're nearing retirement and don't have the time to ride out volatility in the markets or you are simply risk-averse, they have a vital role to play in your portfolio. They're a good income source, too, as many companies in the defensive sectors pay healthy, stable dividends.

Tough ground for ethical investors

However, investing in non-cyclical stocks can prove tricky for ethical investors. "Ethical preferences preclude some healthcare areas, tobacco and even things like arms, which aren't influenced by demand cycles," says Gavin Haynes. "So a lot of areas that ethical investors would want to avoid are non-cyclical."

Indeed, investing in vice has become a way of riding out volatility in itself. A number of managers have invested in tobacco companies in particular, as well as alcohol, gambling and defence firms to help navigate choppy waters. After all, when times are good ­people drink, smoke and gamble. When times aren't so good, they do so even more, as one old saying goes. Neil Woodford, again, is an example of someone who has retained large weightings in tobacco stocks. The fund's exposure to these has fallen slightly over the past year but British American Tobacco, Imperial Tobacco and New York-listed Reynolds American are still big holdings, the latter the biggest in the fund at 5.5% of its invested assets.

So as the credit crunch rumbles on and stockmarkets across the world look set to remain volatile in 2008, can non-cyclical stocks add some stability to your portfolio? While a defensive position can certainly provide a degree of protection, it's worth remembering that by focusing in these areas you could be in danger of missing opportunities elsewhere.

While cyclical stocks that reflect the ups and downs of the economic cycle are likely to fall in a downturn, they will also mirror any rise and offer a potential for growth that way outstrips what you would expect from defensive stocks. Pile into funds with a bias towards defensive stocks and you could be in the wrong place when markets start to recover.

Maintaining some exposure to cyclical stocks may require a degree of bravery during the economic downturn, but if you don't need your money in the short term, sticking with it could be worth it in the long run.

After all, while no one likes seeing the value of their investments plummet, it's a long-term game, and even the best managers don't know exactly when things will improve. So while non-cyclical options certainly have a vital role to play when things get a little choppy and can help prevent your portfolio taking a battering, spreading your investments over a range of assets and funds is as important as ever.

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