Why Defensive Stocks Make More Money

Who would have thought that one of the hot topics of today would be defensive stocks and high-quality investing? 

Just a few years ago it was property, and before that, anything ‘dot com’ was sure to make a bundle.  But things do change, and today, more and more research is finding that defensive stocks with consistently high profitability are one of the best long-term investments.

Of course, Warren Buffett has long professed his love of wonderful businesses with enduring competitive advantages; those that are able to generate large amounts of cash consistently and either re-invest it internally at high rates of return or pay it out to shareholders as a growing dividend.

A recent paper from GMO’s Quality Strategy team uncovers more reasons why defensive stocks tend to make good investments.

In their paper, the authors, Chuck Joyce and Kimball Mayer, make the following key points:

1. Low risk means low risk to future profitability

Most investors would probably measure the riskiness of an investment by how much the share price changes over time, which is typically measured relative to the wider market and is called Beta.  For value investors, this is usually seen as a mistake since it measures the volatility of the investment rather than what most other people would consider risk, which is the permanent loss of money.

As the report points out, Ben Graham said that real risk was:

the danger of a loss of quality and earnings power through economic changes or deterioration in management.

This is because, in the long run, share prices are driven by earnings, so a fall in long-term earnings power is likely to lead to a permanently lower share price.

So, the first point is to look for companies where there is little risk of future earnings being permanently lower than they are today, or as the paper puts it:

“This argues strongly for a risk and investing framework focused on the survivability of corporate profits under any scenario.”

2. There are persistent winners and persistent losers

Economic theory says that if a company is highly profitable (relative to the risks involved), then competitors will be attracted, and the company’s profitability will be reduced.   For most companies this is true, but at either end, there are tails of companies that do consistently better than average or consistently worse.

Those that do consistently better include many that would be labelled as defensive stocks.  There can be a variety of reasons for their success, mostly relating to competitive advantage.  For example, it could be down to:

• Superior branding
• Franchise value
• Intellectual property
• Regulatory barriers
• Network effects

Regardless of the exact reasons, defensive stocks usually generate profits year after year, often increasing in size as they do so and ultimately, increasing profits lead to increasing shareholder wealth in the long term.

3. There are always some high-quality, defensive stocks to buy at bargain prices

Sometimes the stock market is high, and sometimes it’s low, but the authors found that at all times since 1965, there had been at least some high-quality defensives which could be bought at bargain prices.

Value investors have long believed that the Efficient Market Hypothesis was wrong, or at least not totally right.  If it were right, then no single strategy could outperform the market in the long-term, but this paper is yet another which attempts to show that it is possible to beat the market, and with lower risk to boot.

Over the period studied, they found that companies with lower debts, higher profitability, more consistent profits and a less volatile share price tended to generate higher returns in the long run.

Defensive value investors prefer to get rich slowly but surely

One reason for this mispricing and subsequent outperformance of lower-risk, higher-quality companies is that they do not offer the opportunity to get rich quickly.

Too many investors see the stock market as a casino and a way to make some big money fast.  You cannot do that with large, stable, ‘boring’ companies that pay dividends.  So investors pile into smaller companies that are either growing very fast or are potential ‘turnaround’ situations that could become ten-baggers overnight.

Of course, some people do make money using those strategies, and some of it may even be down to skill rather than luck.  But personally, I like to keep the risks low and the returns high.