Read this If You Think Defensive Stocks May Protect You from the Next Market Crash - Smart Contrarian by Equitymaster
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Read this If You Think Defensive Stocks May Protect You from the Next Market Crash

Nov 24, 2017

Rahul Shah, Editor, Smart Contrarian

I am unsure of its origins, but there's a common belief that investors should shift to defensive stocks if they see a market crash coming.

Defensive stocks are known for their steady dividends and stable earnings. Therefore, the rationale goes that they don't correct much during a stock market crash. Your wealth is protected by making an investment in these stocks.

Defensives and the 2008 Crash

No one can question the fact that stocks like Asian Paints, HDFC Bank Ltd, Hindustan Unilever, ITC, and Nestle are classic defensive stocks. They are stable, they give out a steady stream of dividends and what is more, some of them are growing at rates that could put even mid and small caps to shame.

Therefore, the idea of investing in these stocks in an overheated market does seem like the right thing to do.

Guess what, the idea did work like magic during the 2008 stock market meltdown. The year 2008 was brutal for the Indian stock markets. Start to finish, the index was cut in half, losing a whopping 52%.

How did the portfolio of these defensive stocks, assuming you invested equally in each of these, do?

Collectively, they lost just 13%, outperforming the index by a massive 39%. In fact, one of them, Hindustan Unilever Ltd, even went on to give a positive return of 17%.

Looking at this alone, no one can question the logic of getting into defensives the moment the stock market starts ringing alarm bells. The strategy does seem to work.

More than Meets the Eye

However, this is only part of the story.

The reason defensives did well was because they were significant underperformers in the whole bull market between 2003 and 2007.

Yes, you read that right. Collectively, the group couldn't even outperform the benchmark index, underperforming the Sensex by as much as 20%. And since they didn't go up a lot, they didn't come down a lot during the meltdown.

But the story is different this time round. From the lull of 2008, these stocks are up a whopping 7.5x. Every Rs 100 invested in this group of stocks has turned Rs 750, a CAGR of 25%. That's huge.

And how has the Sensex done? Well, it is certainly up but not even half as up as the group of defensive stocks, gaining only 3.4x.

What this has done is, taken the valuations of the so-called defensive stocks to unimaginable levels. Some of these are trading at valuations that are at lifetime highs. Is this sustainable? Looks unlikely to me.

Wouldn't it be fair to conclude then that defensives may not provide the kind of protection they provided during the previous meltdown? For all you know, they could correct even more ferociously than the benchmark index.

If you still want to take a chance with defensives, please go ahead and do it. As far as subscribers of our Microcap Millionaires service is concerned, I am advising them to get into a much safer asset. An asset that won't correct 30%-40%, is available in abundance, and among the most liquid out there.

There's no better protection than being in cash in my view. Which is why the Microcap Millionaires service is sitting on more than 65% in liquid fixed deposits right now.

The moment there is panic and a correction in stocks, it can use its big hoard to scoop up some solid stocks on the cheap end of the spectrum.

This is one of the big reasons the service is up a strong 172% since its inception in February 2014, as against the 64% returns given by the Sensex. It always had enough liquidity on call whenever attractive stock opportunities presented themselves.

Good investing,

Rahul Shah (Research Analyst)
Editor, Smart Contrarian

Brain Food for the Day

Even Warren Buffett Swears by Cash

The value of cash is not lost on the world's most successful investor either. However, he also cautions against keeping more of it than necessary. Here's his view on the topic.

  • "The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Cash is going to become worthless over time. But good businesses are going to become worth more over time. And you don't want to pay too much for them so you have to have some discipline about what you pay. But the thing to do is find a good business and stick with it. We always keep enough cash around so I feel very comfortable and don't worry about sleeping at night. But it's not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially."

And exactly how much is enough?

We vary cash levels in Microcap Millionaires depending on where the broader markets are. If the stock markets are trading cheap and plenty of opportunities are available, we recommend being only 25% in cash and the rest 75% in stocks. And when it is the opposite, i.e. when markets look expensive, we recommend the reverse, i.e. 75% cash and only 25% equities. While these ratios are not cast in stone, it is always a prudent idea to be at least 25% in each asset class at all times.

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