What’s a defensive investor to do?

Being a defensive investor has been tough over the last few years.

Well, more than the last few years, really. As fund manager Perpetual points out…

“Since the GFC, value-oriented equity strategies have underperformed their growth counterparts – not just in Australia but around the world. Rather than revert to the mean, cheap stocks have exhibited a frustrating pattern of staying cheap. Meanwhile, almost any company delivering growth (seemingly regardless of whether it’s organic or purchased) has experienced significant multiple expansion.”

So those dividend stalwarts have struggled. The “cheap” stocks you bought, because you’re a value investor haven’t delivered. And it’s not even a problem we can sheet home to the mining bust or underperforming banks.

Not only have the value crowd been hurting, but those who have been predicting doom and gloom have suffered, too.

If you were getting your portfolio ready for disaster – by avoiding “growth” stocks that were going to suffer most in a downturn – you’ve fallen behind.

Normally, of course, cash would be a safe haven for the defensive investor. With term deposit rates delivering maybe 2 or 3 per cent, you might have saved your money from volatility… but unless you have millions stashed away, it’s hard to live on.

Now, if avoiding volatility at all costs is your aim, I don’t have a better solution than cash.

But remember, the “at all costs” bit isn’t just a rhetorical flourish – dodging ups and downs really will cost you.

But if, like me, you know that earning decent returns means embracing a little volatility, where’s the best place for a defensive investor to put their hard-earned?

First, ignore the crowd.

The usual suspects – read: banks – have been even worse than the cash in them, with only Commonwealth Bank of Australia (ASX: CBA) showing a positive capital return over the past 12 months.

Instead, defensive investors should look for defensive businesses.

Sounds straightforward, but forget what you think you know.

If you’re worried about worse times ahead – say if China does have a hard landing or Aussie house prices fall – look for the businesses that’ll fare best.

But before you buy them, check out their value, too. Banks were defensive, but expensive. And Primary Health Care (ASX: PRY)  – what’s more defensive than that – saw its government funding cut. Choose wisely.

So what should you buy?

Maybe grab a health insurer like NIB Holdings (ASX: NHF) and perhaps a car parts wholesaler like Bapcor (ASX: BAP).

Telstra (ASX: TLS) is obvious, but for a reason – it’s super-defensive because it’s equally ubiquitous.

Add a dash of overseas exposure like bionic ear company Cochlear (ASX: COH) whose customers are always going to need it, and round out the list with a listed investment company like Washington H. Soul Pattinson (ASX: SOL), whose management will take advantage of any bargains they’re offered if the market swoons.

None of those companies are immune from falling markets. But that’s volatility. What a defensive investor should really be worried about is the chance of a business’ value being permanently impaired.

As Perpetual also notes…

“With valuations stretched and investor sentiment diminishing, the scene is set for volatility in equity markets to be ongoing. Importantly, quality stocks tend to outperform amid increased volatility.”

I’m not a fan of forecasting market behaviour. Either such a forecast is necessarily vague (and so almost always right) or unduly specific (and then, just as likely wrong as right).

And trying to avoid volatility is, well, crazy, because it’s impossible – unless you want to earn cash-like returns.

That said, I’m with Perpetual when they state a preference for quality businesses.

And if you can find such businesses that also show less business volatility (not to be confused with stock market volatility) the defensive investor gives herself the best chance of success.

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Of the companies mentioned above, Scott Phillips owns Telstra