What is defensive value investing?
Defensive investing at its heart is a simple concept. It looks to defend against an uncertain future by investing in large and successful companies which are more predictable than average. These companies are typically in industries which are not unduly affected by recessions and economic downturns.
The classic defensive company is in the pharmaceutical, utility or consumer staple industry. They make things like toothpaste, soap and electricity which people need whether there’s a recession or not. They also tend to sell products which are price “inelastic”, in other words, if the price goes up people will keep buying.
These traits tend to result in defensive companies producing consistent, growing sales, profits and dividends, all of which is music to the ears of most investors.
Recent research has also supported the idea that low risk companies (or low “beta” to use the jargon) really have outperformed the market over time, which is the opposite of the standard mantra that you need to take on more risk to get higher returns.
So defensive investing provides a whole suite of attractive features to investors. You get a relatively low risk portfolio which is less stressful and easier to live with; you get a steady income which should keep up with inflation, and you get companies that produce reliable, positive news, whether the economy is doing well or not.
But there is a risk lurking out there which has nothing to do with the quality or defensiveness of the company you’re investing in. You could invest in the most defensive company in the world and still face this risk.
If you unwittingly take on too much of this risk then your investment could decline by 50% or more, even if the underlying company continues to do well.
It’s called valuation risk, and it comes from owning companies where the share price is far higher than it deserves to be.
The good news is that it’s possible to increase returns and reduce valuation risk by making sure that when you buy defensive investments you get as much “value for money” as you can.
When it comes to the stock market value for money means getting as much revenue, as much profit, as much cash flow and as big a dividend as you can get for your money.
In the same way that you would want to buy an investment property cheaply relative to its rent potential, you should be looking to by companies as cheaply as possible too.
By combining a defensive stance with a keen eye for value, a defensive value investing portfolio should be:
- Defensive in nature: It should be a diverse collection of high quality, market leading companies with long histories of growing profits and dividends.
- Value focused: It should carry little valuation risk, i.e. it’s unlikely to fall excessively because it’s full of shares whose prices are already low. It should have higher earnings and dividend yields than the general market.
- Investing for the long-term: It should avoid frequent and costly switching from one investment to another by owning companies for years rather than months. It should be focused on long-term returns, not which way the market will go next week, next month or next year.
Why defensive value investing?
Since the financial crisis and market crash of 2007/8, defensive investing has become very popular, and it’s easy to see why. We have had what seems like an endless flood of bad economic news, tinged with talk of great recessions and depressions. Investors now want a “safe haven” where they can put their money to work and insulate themselves from uncertainty and capital loss.
This is a sensible approach and there is a lot of evidence, both real-world and academic, that investing in high quality, defensive companies is a good way to invest.
But once we are out of this crisis, most investors will go back to what they were doing before, and what they were doing before was to make three basic mistakes, over and over again. These mistakes result in the average active investor’s portfolio being worth approximately half what it could have been over a 25 year period.
Defensive value investing is one way to avoid these mistakes, and I think it would be helpful to expand on what these mistakes are, and more importantly, where they came from.
The roots of these mistakes lie in the simple truth that when it comes to the stock market, the future is very uncertain. There is uncertainty about the prospects for each company, about whether share prices will go up or down, and about whether or not the next dividend will be paid.
This uncertainty leads to fear, or perhaps more accurately, anxiety.
This anxiety is unpleasant, and so people look for ways to avoid it, but the methods that most investors use to reduce anxiety are expensive because they lead to massively lower returns in the long-run.
Not everybody feels anxiety about their investments. Some people hand their investments over to an advisor or a pension fund manager and never look at the value of their portfolios. These investors do not have the anxiety of investing, but they still pay a price for offloading that anxiety to somebody else in the form of fees, which may still massively reduce investment returns in the long run.
For those investors who actively manage their own affairs, there are three main strategies that they take to avoid anxiety, and they are all poor choices.
Holding more cash or bonds
The most obvious way to avoid anxiety from uncertainty is to avoid it. This typically means holding more cash (certainty of capital value but uncertain income) or bonds (certainty of capital value and income). Of course the downside of this approach is that both cash and bonds provide lower total returns than the stock market, therefore these are expensive ways to reduce anxiety.
Another way to reduce anxiety from uncertainty is to do what everybody else is doing. Humans are social animals and this desire to do what everybody else is doing is a very powerful instinct. No matter how daft our collective actions may be, very few people are comfortable being the odd one out.
When it comes to investing, following trends and doing what everybody else is doing is embodied in the simple strategy of buying shares that have already gone up, and selling those that are going down.
The logic is powerful: If everybody else is buying (or selling) then surely they must know something that I don’t.
The emotions are also powerful: By doing what everybody else is doing I will gain comfort and certainty from being part of a group, and if we’re wrong then at least we’re all wrong together.
Believing in speculative stories
In the face of uncertainty it’s common to tell stories; that’s the basis of most religions. It’s also the basis of the trend following strategy, where the story is that the crowd must know something. That story, and most speculative stories, often have little to do with reality.
Speculative storytelling is incredibly popular. All of the TV channels dedicated to investing and the economy are filled with virtually nothing but stories. Newspapers are by and large the same.
Stories come in many forms, such as “Company X has had a profit warning, so it’s likely to struggle for the next few years and I should sell”, or “ Company Y has launched a successful new product, therefore it’s going to dominate it’s market and so I should buy”.
This sort of storytelling about companies and the economy is the way that almost everybody invests, but in most cases it just doesn’t work.
The stories we weave sound plausible in our heads, but reality doesn’t care. It will pan out in ways that we can’t imagine because the world is so unimaginably complex.
There are trillions of interactions every second between people, companies, governments, the weather and many other things. Each of these interactions creates unpredictable consequences. These consequences multiply over time and that is why the future is so uncertain.
Storytelling is a natural way to cope with this uncertainty and in many situations, such as building a shared culture, it’s useful. But investing based on speculative stories is a bad idea.
Avoiding uncertainty by holding more cash or bonds has an obvious impact on returns because everybody knows that stocks have higher returns than cash or bonds in the long-run. It’s a simple trade-off between risk (uncertainty) and return.
But trend following and speculative storytelling also have a significant impact on investment returns, and their impact shows up in the three basic mistakes that most self-directed investors make.
Mistake #1 – Buying high
Everybody knows you should buy low and sell high, but that’s not what most active investors do. Because of the desire to follow the trend and follow the crowd, they generally buy what has already gone up, and buying what has already gone up means that you’re more likely to be buying high.
A reasonable estimate is that repeatedly buying high loses the average investor about one percent of their portfolio every year.
Mistake #2 – Selling low
The opposite of buying high is selling low. Again, investors are driven to follow trends so what has recently gone down will, in their minds, keep going down. The idea that the crowd has wisdom will also lead the follower to think that the crowd must have a good reason for selling; therefore selling along with them is a good idea. This leads to a fairly consistent pattern of selling low, which probably costs the average active investor about another one percent of their portfolio each year.
Mistake #3 – Buying and selling too often
The stock market is a volatile place. If you look at the chart of any stock you’ll see that it goes up and down every day, every week, and over every other time period.
Investors who follow trends have a tendency to get “whipsawed” out of the market, when a stock that was going up suddenly decides to go down.
Regardless of the reason for the drop, when it drops a lot of investors will jump ship.
Shares are volatile enough that if you buy on the way up and sell on the way down then you will end up buying and selling quite frequently, and the more frequently you trade the more frequently you run up expenses such as broker commission and stamp duty.
Investors also buy and sell frequently when the story they bought into turns out to be wrong, or at the very least, reality refuses to do as they expected it to.
If you invested in a company based on an event that you thought was going to happen next year, and then the event doesn’t happen, what do you do? Many investors would sell and go looking for another “story” to invest in.
This is exactly what most active investors do, and the end result is that they switch from owning one company to another far too often, losing at least one percent a year of their portfolio’s value from trading costs.
If the main problem that most investors face is that they buy high, sell low and trade too often, and that each of these mistakes is driven by poor strategies to avoid anxiety, one possible solution seems clear: Reverse each of these problems and turn them into strengths rather than weaknesses.
- Instead of buying high, buy low
- Instead of selling low, sell high
- Instead of buying and selling frequently, do it infrequently
- Instead of being anxious about your investments, structure each step of the investment process with the specific goal of reducing anxiety as much as possible without reducing returns
This is exactly what defensive value investing sets out to do.
When you buy low and sell high you are by definition holding investments that represent good value for money. When you buy and sell infrequently, perhaps holding each investment for 5 years or longer, it’s a good idea to hold companies that have a good chance of growing over that timeframe, and that’s what defensive investments are all about. And if you’re looking to reduce anxiety, then defensiveness is a very powerful way to do it, without sacrificing returns.
How this strategy developed
I started out as an investor back in the early 1990s. I did the sensible thing and invested primarily in a passive FTSE All-Share tracking fund. I remember having read something about how passive investing took advantage of the aggregate skills and knowledge of all the other market participants. It was (and is) like having a vast army of analysts working for you – for free – to make sure your investments are valued correctly.
The 90s were one long bull market, so investing back then was easy. You put money into a tracker and, as if by magic, it went up by ten or twenty percent every year. It was easy money.
That all changed in 2000 when the market started to head south. By 2003 my investments were down by almost 50% and I had no idea why. I did what most investors do when they don’t understand what they’re invested in. I ignored the declines, telling myself that they were just market “noise”.
Then, as the market fell further I began to feel the cold hand of fear which, for a year or more, I was able to bear. Eventually my fear turned to panic as the market continued to fall further than I thought possible.
Unable to take the stress of seeing my dreams of financial independence go down in smoke I sold everything, acting out my role as novice investor to a tee.
The moment I sold (or so it seemed) the market turned around and promptly headed straight back up, gaining about 30% by the end of that year.
My initial response was confusion, and then depression. I thought about getting back into the market but fear and uncertainty kept me out.
The “market” was supposed to be rational, but I was wrong. I had two options:
To stay in cash until my fear of getting back into the market faded. This is a common approach and it usually leads to investors getting back in towards the end of a bull market, just in time to participate in the next bear market.
I could knuckle-down and work towards a better understanding of the market.
The intellectual challenge of understanding the market was too tempting to ignore, so I decided to educate myself on what the market was really all about. I wanted to know how I could avoid the fear (and losses) I had in 2003, while achieving the kind of stock market returns that history suggests are on offer.
Initially I spent a few years researching and investing in efficient asset allocations using modern portfolio theory. This involves understanding the workings of the standard deviation of returns and the covariance between different asset classes, and how different combinations of different asset classes affect the whole portfolio.
This is why the strategy in this book is focused on the results of the portfolio as a whole, rather than the individual companies. But eventually I became more interested in stock picking, and value investing in particular.
I then spent several years as a “deep” value investor, buying small, struggling companies that had strong balance sheets and the potential to turn around. These investments often proved wildly successful. The also occasionally went bust. This is a valid strategy, but I found it too depressing owning companies where they always seemed to be laying people off, and I also didn’t like the highly uncertain prospects of each company.
Eventually I moved towards defensive value investing, which I found after reading much of the material on and from Warren Buffett. The combination of buying high quality, consistent companies at attractive valuations made a lot of sense, and I subsequently spent over a year developing the first version of this strategy, which now continues to evolve over time.
Why write a book about it?
The obvious thing to do if you have spent years developing an investment strategy that seems to work is to keep it a secret. So it’s a reasonable question to ask why I’m writing a book which will help other investors and perhaps give them an information edge over me.
The answer is that in 2009 I saw something which made me realise that I wasn’t the only person who made bad investment decisions. I realised that there were many other investors out there who either didn’t know what they were doing, or didn’t have the tools and systems that they needed to succeed.
Someone I know had recently inherited a reasonable sum, shortly before the onset of the financial crisis. An advisor from his bank duly came round and decisions were made as to where the money should be invested.
My friend was happy to take on a significant amount of risk because he wanted the money to grow, and it was to be a long-term investment so short-term risk was not important.
And then the financial crisis crashed into his portfolio like a tornado.
I’m sure that today he would be in profit from his original position, if he had stuck with the investment. But he didn’t. He did what so many people do who have some control but no understanding of their investments.
He sold, just as I had in 2003, and halved his inheritance in less than a year. Shocked by how savage the market can be, he made his second mistake and is still sitting in cash today.
What gets to me is that I knew what the market was doing, and I could have helped steer him, at least to some extent, through those turbulent times. But I didn’t.
It’s not really in my nature to get involved in other peoples’ business, and I’m not fond of other people getting into mine. I’m a classic INTP, I don’t like telling other people what to do and I don’t like being told what to do.
But in this case I felt I should have done something; that I had some sort of moral obligation to help.
I guess to some extent that’s why I started spending more time writing articles on the internet. This eventually resulted in me starting my investment newsletter in 2011 after I was made redundant by my previous employer.
While I think most jobs in the UK are socially useful I thought that this could be the best opportunity in my life for me to do something which I really enjoyed (developing investment strategies and tools and writing about them) and also helping other people to achieve the financial independence that they were after too.
Writing this book is just an extension of that idea. My hope is that as many investors as possible who are not satisfied with their returns are able to improve their outcomes by using this book.
This book details a very particular approach to defensive value investing. It’s a strategy and a series of steps that I have developed over a number of years using, to a large extent, my background in software analysis.
Software analysis is basically about understanding systems, specifically, repeatable, logical systems. You’ll see that a lot in the general approach. The strategy as a whole is structured and systematic, as is each sub-section like company analysis, or valuation, or portfolio construction.
The creation of this strategy comes from a slightly different direction that is typical for most stock picking strategies in that my interest is primarily in portfolio construction rather than the selection of particular companies.
I am more interested in how the portfolio as a whole is built, and how it behaves. More so that I am in exactly what companies are in it, or their precise characteristics.
So for example, I am happy to have cyclical companies in a defensive portfolio, as long as they are growing steadily across the whole business cycle, and as long as they preferably have a progressive dividend policy.[TO BE COMPLETED…]