Bluechip: Defensive theory that fails to hold water

In a bear market, the hunt for stocks to eliminate uncertainty can become all-consuming, writes Richard Phillips.

Shares where revenues flow in as surely as, well, the Thames flows along its course become all the rage. The theory is that such shares will, at the least, do less badly than the rest.

Defensive stocks then, which carry a premium for the protection they are supposed to offer investors - and the latest sector to be seized on for these purposes by the stock market is water.

Everyone needs water, goes the argument, somewhat oversimplified, so profits for these companies will be immune to economic downturn. While there is a certain undeniable logic here, are companies like Thames as impermeable as some would suggest, or might profits prove as leaky as their pipes?

They face problems aplenty, especially from their regulator, Ofwat. Its head, Ian Byatt, has once again upped the stakes for water stocks, after he pointedly asked how much longer water stocks can continue to generate dividend growth at current rates.

Defensive stocks must offer some proof against the vagaries of recession. In the last 10 years, water shares, taken together, have outperformed the main market by a tidy margin. Outperformance, though, has slown considerably in the last five years. Labour's windfall tax helped take the wind out of the sector's sails.

With the next price review not until 2000, there is little the regulator can do in the immediate future. But what sort of return investors can expect is less clear. More share buy-backs can be expected - South West Water could be next.

On one reckoning, the sector could have enough growth - especially if the multi-utilities are included - to merit a premium rating. But it is more difficult to argue that water stocks are truly defensive. There is too much going on in the sector.