Smart Investor: Getting Started, March 2013

Smart Investor, March 2013

Getting Started

Whenever a market appears to turn a corner or take a new direction, it’s common to hear investment professionals talking about a shift between defensives and cyclicals. It has been a popular discussion during this promising start to the year in equity markets, as stocks globally have rallied on a collective sense that what’s ahead is less scary than what’s behind us.

What does it mean?

Expressed simply, defensive stocks are those you can’t do without. No matter how bad the markets, how deep the recession, these are not purchases you’re going to be able to avoid making: bread. Toilet paper. Electricity.

Cyclicals are those that thrive in the good times. When the economy is running hot, people might buy a new car, a stereo, a holiday, or fancy clothes. When times are tight, all of those are things that can be put off because they’re not vital.

So, in practice, defensives are things like consumer goods of the essential kind – so food, beverages, household products, toiletries and packaging. It’s commonplace to include tobacco here too – a luxury, but also an addiction, and therefore somewhat recession-proof.

Other defensives include the healthcare sector, such as pharmaceuticals and hospitals, and utilities, which provide us with gas, electricity and water. Classic Australian defensive stocks would include Woolworths and AGL; global stocks would include Procter & Gamble, Nestle, and Johnson & Johnson.

Within the cyclical sector come a range of industries. Most obviously, there are consumer cyclicals, which include retail businesses, the automotive industry (including automotive parts), restaurants, entertainment businesses like cinemas, and also residential construction. Real estate companies also tend to be cyclical. Linked to that, basic materials are cyclical too, since those basic materials are in demand in order to make the other cyclical things: in this basket come chemicals, building materials and paper, as well as commodities companies like miners. One can argue that banks, asset managers, brokers and insurance companies are cyclical too, although that is more debatable.

So Australian cyclicals would include BHP Billiton, Nufarm and Macquarie. International cyclicals include Toyota, McDonald’s and Goldman Sachs.

Some consider there to be a third camp. Morningstar Research, for example, talks about sensitive sectors – those that don’t have much correlation to business sectors, like technology, communication services, energy and industrials.

These definitions are not always clear, and are open to debate. Consider Telstra, for example, which in Morningstar’s definition would be a sensitive stock. But doesn’t everyone need a phone line so they can communicate, in good times or bad? In that case you’d think of it as a defensive. But doesn’t Telstra offer discretionary services, luxuries really, like high-speed internet connections you’d like but don’t really need? That sounds more like a cyclical. Similarly, how about banks? On the face of it there’s nothing more steady and reliable than something like the Commonwealth Bank of Australia or Westpac, because they hold deposits. They also pay out reliably high dividend yields. But they’re also cyclical, because they make money from borrowing and lending, and in hard times will lend less and suffer defaults in their existing loans.

Still, you don’t need a cast-iron definition of which stock fits which basket to find this a useful gauge of the way the market might perform. Defensives do well when confidence in the economy is low; as the sense grows that a revival is taking place, momentum shifts to cyclicals. Some investors, particularly those known as growth-style investors, base a large part of their investment decisions on these swings: not just looking at how good a company is, but whether it is in a part of the market that is going to be caught up in momentum regardless of its standing within its field.

Naturally, deciding if a stock is defensive or cyclical, and which of those the market is likely to favour, is only a small part of an investment decision. No matter what sector it’s in, a stock’s price is vital. A defensive stock can still be a good investment in a booming environment if the price is right. And a cyclical stock can still be a bad investment in apparently perfect circumstances if it is already too expensive when you buy.

Another useful term to understand is “risk-on” or “risk-off”. These expressions have been all the rage in global finance ever since the financial crisis, as asset managers have wavered about whether it’s a good or a bad time to be buying relatively high-risk assets. This debate covers all sorts of asset classes – whether people should be holding boring government Treasuries or high yield bonds; whether they should be hoarding gold or buying global stocks – but as a general rule, in a risk-off environment, investors have decided it’s a bad time to be taking risks and so will favour defensive stocks. When things look brighter and people want to take a little risk in pursuit of returns, that’s a risk-on environment, in which people are more likely to buy cyclicals.