On the defensive

Minimising risk during a precarious stock market period requires a variety of tactics. Rachel Fixsen asks the experts for advice

When storm clouds gather on the stock market horizon, small investors might be tempted to run for cover. But short of selling everything remotely resembling a share and sticking the lot in a deposit account, how exactly can you defend yourself?

It all depends on what type of risk you want to minimise and what your personal view of the market is. For instance, if you fear a major correction on the UK stock market, you could diversify your stockholdings into foreign shares. Or if you are worried about an even stronger pound breaking the legs of UK exporters, stick to shares with no exposure to foreign markets.

Using collective investments such as unit trusts and investment trusts keeps your money safer by spreading your exposure to individual shares, and using some of your portfolio to buy Gilts or other bonds at least protects part of your investment from stock market turbulence.

But however much you may want to employ risk-avoidance tactics, make sure it makes sense from a tax point of view, stockbrokers warn. Selling off a holding may well involve realising a capital gain, leaving you liable to pay capital gains tax.

How would stockbrokers shape a hypothetical pounds 100,000 defensive investment portfolio?

David Carroll, of Barclays Stockbrokers is not worried by the current state of the market. "I actually think this is one of the short-term blips," he says. Having been very heavily into cash for the first few months of this year, he says he is now buying shares. "But I still wouldn't go jumping in entirely at the moment," he adds. For that part of the portfolio in equities, he advises sticking with UK stocks and being selective about global players.

On Mr Carroll's list of defensive buys are: Barclays, because bank stocks have seen a virtual crash in its prices recently and the downside in this sector is certainly limited from here; Glaxo, which may well be the most volatile on this list but the company is globally diversified, selling products almost everywhere in the world; Land Securities, which is likely to benefit from falling interest rates over the next few years; and Whitbread, which has UK-only earnings, saving it from the battering that fluctuating exchange rates can give some stocks. Kingfisher, Marks & Spencer, British Telecom and Tesco are also on his buy list.

A defensive investor should avoid information technology stocks, Mr Carroll says. The shares are trading at inflated levels, having priced in huge profit growth expectations. Some will need to have profit growth of 25 to 30 per cent a year for at least the next four years to justify today's prices, he says.

Steer clear of smaller companies. "When the economy tightens, the companies that benefit are the bigger ones because of economies of scale," Carroll says. Second line retailers such as Oasis and Debenhams do not belong in a defensive portfolio, he says.

Michael Winson of Henderson Crosthwaite, another stockbroking firm, says a pounds 100,000 portfolio is best restricted to collective investments rather than individual shares. Upfront charges of around 2 per cent for investing in the shares of a single company make it uneconomical.

To play safe, a proportion of the portfolio should be held in zero-dividend preference shares. "With these, any fall back in the market will always be well covered," he says.

They should yield around 6 to 6.5 per cent capital growth and are very low risk.

Slightly further up the risk scale are income shares in an investment trust. Investment trust shares are now trading at a discount of 10 to 20 per cent to their net asset value.

"There is a little bit of a buffer there and that will also give you extra gearing if the market does race," says Mr Winson.

Investing money in an OEIC (Open Ended Investment Company), which is usually run offshore, can give great flexibility. These are often umbrellas sheltering a number of investment funds. Once invested, you can switch between the funds, depending on the market outlook at the time, for very little money, Winson says.

If you are sceptical about where the market is going, keep a proportion of your portfolio invested in a bear fund, he says. A bear fund uses derivatives to go against the market's direction. "If the market falls back it goes up in value," he adds.

For a defensive stocks portfolio, the secret is to use a combination of shares, says Winson, where, if one falls in value, the others are likely to rise. Utilities - particularly water stocks - would be suitable, and have no overseas exposure. On the other side, pharmaceuticals would also fit, being global players. Glaxo Wellcome and SmithKline Beecham are both at good buying levels, Winson says.

Telecommunications stocks and IT stocks should be avoided. "They have had exceptionally strong runs and may be first to be hit in bouts of profit taking," he says.

William Davies, of Albert E Sharp, says for a defensive investor the portfolio should be split into cash, low-risk investments and equities. About pounds 10,000 should be on instant access. As a low-risk investment, he would recommend pounds 20,000 go into a with-profit bond and a further pounds 15,000 into fixed-interest securities. The rest should be in shares. "This may appear high in the context of a 25 per cent rise over the last year in the UK, but I believe good quality equities provide the greatest protection against real capital erosion over time," says Davies.

Among shareholdings should be Shell, British Aerospace and SmithKline Beecham. GUS - best known as the leading home catalogue company - is another good holding for the defensive investor, Davies says. It also handles all functions related to credit cards, and will benefit from the continuing trend to outsource, he says.

British land is also an increasingly attractive purchase as property is a defensive investment - not only because property markets usually lag equity markets, but also because as interest rates fall, the yield from property becomes higher.