A recession in the UK looks likely. Due to the measures needed to contain the coronavirus outbreak, economic activity is dramatically lower than normal. Many jobs have been lost, perhaps permanently, as businesses go bust, making a recovery more difficult. The stock market has already crashed, and with a recession in mind, many investors may be looking to add defensive stocks to their Stocks and Shares ISAs.
Adding defensive stocks in the face of a recession is a prudent move. However, the companies selected should also make sense in the long term, when the economy will be in better shape.
What are defensive stocks
If a company sells good and services that consumers can’t or won’t cut back on, no matter the state of the economy, then it is likely to be a defensive stock. Companies whose operations are stable over time, that generate plenty of cash, and have strong balance sheets are what to look out for.
These types of companies tend to be more mature and have larger market capitalisations. They also tend to pay dividends, even when the economy is weak and interest rates are low, and thus boost investor returns.
Investors may be familiar with the concept of beta. Beta is a measure of how much an individual share price moves with the market. A beta of 1 means the share moves as the market moves. Defensive stocks tend to have betas of less than 1, meaning they fall less than the market when it declines.
Investors may pile into defensive stocks when the market is crashing, only to see it turnaround and be left behind. If defensive stocks have betas of less than 1, then they rise slower than the overall market does. But, long-term investors should not be looking to time the market. What they should be interested in is adding great companies to their portfolios. If those great companies also happen to be defensive, then all the better.
Where to look
Utilities are good examples of defensive stocks. Whatever the state of the economy, people will need electricity, gas, and water. Shares in pharmaceutical companies and medical device manufactures are good defensive bets because people do not stop getting sick in recessions. Consumer staples companies, like food and beverage producers, also fall into the defensive stock category.
The FTSE 100 contains the largest UK companies and is a good place to begin a defensive stock search. GlaxoSmithKline and AstraZeneca are two pharmaceutical giants paying dividends that are covered well by earnings, suggesting investors will continue to enjoy yields over 3.5%.
I like the look of Halma. This FTSE 100 company markets life-saving technology solutions for industry and healthcare settings. In a statement on 18 March, the company reported that so far the COVID-19 outbreak had had minimal impact on its operations. Halma generates plenty of cash, and its dividend is covered twice by earnings.
Holding at least a few defensive stocks in a portfolio can help smooth out its return during a recession. But make sure any picks make sense in the long- as well as the short-term. Trying to time the market is difficult. Adding defensive stocks now, only to move out of them when things seem to be picking up is not something I would encourage.
James J. McCombie has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. The Motley Fool UK has recommended AstraZeneca and Halma. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.