Professional Investor: Why defensive investment is not so offensive

Back then, it was only human to have some lurking doubts about the potential for old-economy stocks to recover in what was seen as a new era of technology. But a value investor, moulded in the old-school traditions of looking for a low-price earnings ratio along with an above-average dividend yield, should have been drawn to certain stocks.

AB Foods (priced at 305p in February 2000), SABMiller (510p) and BAT Industries (240p) looked attractive, despite the hype surrounding technology shares. As the history books show, old-economy stocks did recover and help to mitigate some of the damage TMT sectors inflicted on so many private investors.

Not only have defensive stocks recovered, many are driving the stock market indexes to new four-year highs. But as share prices rise, where do we go from here?

It hasn't been difficult to be negative of late, despite continuing market rallies. Worries dogging the UK economy have encouraged the bears to warn that a recession is imminent unless the Bank of England and the Treasury take steps to prevent a slowdown.

These concerns include the fear of a concerted UK consumer-spending slowdown, as well as reports of rising levels of bad debt by many of the country's largest banks. Consumer confidence is also being hit by a significant stagnation in the housing market. These factors forced a reduction in base rates by a quarter of a point to 4.5 per cent this month.

Normally at such a point in the economic cycle, investors might consider a move into the defensive sectors. Decidedly old-economy sectors - such as food retailing, food manufacturing, health care and even oil - are the obvious options. Defensive investments are traditionally the shares of companies that are well-positioned to withstand recession, usually because the goods and services they provide are essential items. Sin stocks, such as tobacco, gambling companies and drinks producers, areoften also good defensive options.

But given the old economy's recovery during the past five years, stocks in many of these sectors are already ahead. A snapshot of the picture during the past 12 months reveals that leading shares in these sectors have outperformed the FTSE 100 Index as a whole by an average of 11 per cent. In part, this outperformance may have been in anticipation of a recession, even though one has not yet technically occurred.

For example, shares at SABMiller are up by 45 per cent during the past 12 months. At BAT Industries, investors have made 37 per cent, while Tesco shareholders are 29 per cent better off. Overall, the average performance of defensive sectors since last August has been 34 per cent, compared with 23 per cent from the FTSE 100.

In addition, some defensive shares are beginning to show growth-stock potential. SABMiller is a traditional brewing company that is steadily expanding into emerging markets, where new-found middle classes are consuming more of its products.

Similarly, the oil sector has often been seen as a safe haven within an economic storm, as consumers all need to continue to drive cars to work and so on. But new-found highs across the sector would appear to reveal a lack of investment in new resources during the past 10 years, and political tensions are now bringing that lack of foresight home to roost in the form of ever-rising oil prices.

Given the outperformance of many leading defensive stocks during the past 12 months, the question is: what would happen in the event of an actual recession? It may be that investors will enjoy a double-whammy by continuing to hold such shares during the period of any economic downturn, proving that they are all-weather stocks.

But it is worth remembering that while such stocks could outperform the index on a relative basis - that is, decline less than the stock market as a whole - they could still lose you money in absolute terms.

Keith Bowman is an equity analyst at Hargreaves Lansdown Stockbrokers. cash@independent.co.uk

Sean O'Grady is away