Prior to COVID, a popular approach to defensive equity investing centered on buying lower-risk, higher quality stocks. This makes perfect sense and isn’t very surprising. Also not surprising, this sort of strategy tends to overweight the consumer staples sector. After all, when you are looking for earnings and stock price stability, what type of company could be more resilient than the one that makes your favorite breakfast cereal? You always have to eat, so you’ll always buy that cereal. Unfortunately, the shutdown last year provided a unique (and previously unimaginable) way in which this turned out to be untrue. You may still need to eat breakfast, but you may not be buying that particular cereal if the grocery store is closed, there are supply shortages, or you decide to forgo the trip to the store and your Instacart buyer purchases a replacement instead of your favorite. In this way, consumer staple companies – and a classic defensive equity strategy – failed to provide investors with the expected downside protection in the aftermath of the pandemic-induced closures.
Another traditional defensive equity strategy focuses on stocks with lower valuations. The rationale is also straightforward: when you buy cheaper stocks, you have a greater margin for safety. This strategy also ran into problems during 2020. Many value-oriented sectors like energy, materials, and industrials are cyclical, and companies in these industries are highly exposed to economic conditions. So, when the economy shut down last year, these companies suffered, and the value strategies that invested in these companies failed to mitigate investor losses.
In contrast to these classic approaches to defensive equity, during 2020, a stronger tactic involved buying the ‘stay at home stocks’ that were most likely to benefit from COVID-related behavioral shifts. Companies that helped people work, learn, exercise, shop, and learn from home generally outperformed when the market was weak last year. Interestingly, this strategy naturally leads investors to the technology sector which, prior to the Coronavirus, was not thought of as a defensive sector.
Also successful in 2020, understandably, was an approach that concentrated on the biotech firms involved in the testing, vaccination, and treatment of the virus. These investments performed well during much of the year but began to underperform the market late in 2020 when investors turned their attention to the economic reopening and government spending. Still, when the market experiences virus-related down days (as it did for a short period due to the delta variant), biotech firms have continued to exhibit resilience.
As economic projections have waxed and waned along with the virus’ case count, the relative merits of these defensive approaches have also changed. At the same time, the perception of investment risk continues to evolve as the focus of investor worry shifts between medical, political, and macro-economic issues. In such an environment, finding the “right” defensive equity strategy can seem like guesswork.
Fortunately, there is one bright spot. Whereas at other times many stocks go up and down in unison, in the current atmosphere there is great dispersion between equity strategies. The correlations between the different approaches and sectors mentioned above are at the low point of their traditional ranges. This means that allocating to several different strategies will provide significant diversification benefits. In the current setting, choosing any single defensive equity strategy may not be the best defense, but an approach that incorporates all of them may help protect investors from a variety of potential risks.