A lot of investors spend time worrying about the prospects of a stock market crash. But I do not think a crash is bad news for everyone involved. It might offer me the chance to pick up what I think are high-quality shares for an attractive price, for example.
The theory of defensive stocks
One class of shares that sometimes (although not always) bucks the trend in a crash is what are known as defensive stocks. These are shares that have resilient customer demand. They may therefore be seen as being something of a safe haven in times of market crisis.
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For example, no matter what happens, people still need to eat – so Tesco will keep making sales. People will still wash their hair, which should help sales at Unilever. Households will still need to use water, which could support sales at Pennon. Or so the theory goes.
Defensive stocks in a stock market crash
Defensive stocks can indeed do well in a crash, but I think it can be difficult to know how defensive a share really is. For example, during lockdown, people left their homes less often than before. It turned out that, although people still washed their hair, many did so less frequently when they were not going outside their homes regularly.
People still needing to eat indeed helped sustain sales at Tesco. But that did not protect the shop chain from the additional costs imposed by a pandemic, such as installing protective screens. Between 2019-20 and 2020-21, Tesco revenues only fell by 0.4%. But its operating profit slipped 21.3%.
Even utilities are not always as defensive as they may seem. A worse financial environment can lead to more customers not paying their water bills, for example.
If many investors move into defensive stocks as a perceived safe haven, that can push their price up during a crash. But I also think it is important to consider how defensive a share really is. I would not buy shares for my portfolio purely because they were defensive. I look for high-quality companies that can hopefully generate substantial free cash flows in the long term.
Look at the cause for a crash
Often there is a specific trigger for a stock market crash, even if sentiment has already been weakening for a while. For example, it could be a sudden sense that a particular group of companies is overvalued, as we saw in the dotcom crash. Or it might be a sudden dramatic event like we saw in 2020 with the onset of the pandemic.
Understanding the key immediate cause of a crash is helpful in my view. It may help me understand which stocks might actually benefit from the crash. Take the 2020 implosion as an example. If a pandemic arrives and people are worried about virus transmission, companies focussed on hygiene could well benefit. By July 2020, Dettol owner Reckitt saw its shares trade 25% higher than at the start of the year. That was despite a fall during the March crash.
If the underlying cause for a stock market crash can improve the long-term outlook for a company, it could support its share price in the crash – and beyond. That is the sort of company I might consider adding to my portfolio.