Strategies to stay safe

Recession fears, persistent inflation, high interest rates, the war between Israel and Hamas: these days there are many reasons to protect yourself from stock market fluctuations by adopting a defensive investment approach. Where can we find shelter from the headwind? Four experts speak.

Each week brings its share of new economic data that can make forecasts risky. Where will interest rates be in six months? Will they start to decline or stay high? Will economic growth be weak, zero or downright negative? Not to mention the unpredictable conflicts in Ukraine and the Middle East, which could have an impact on oil prices and therefore inflation.

In this context, it is normal for investors to be tempted by defensive securities, which basically have the advantage of resisting economic shocks. “Defensive stocks are always in my arsenal, but they’re especially so right now,” says Steve Goulet, wealth management consultant and portfolio manager at National Bank Financial. If we do get into a recession, we want companies that have less debt and more free cash flow, which gives them the flexibility to seize opportunities that may arise. »

Limiting your portfolio’s exposure to risk can be an interesting path, provided you do it in moderation, adds Jean-Philippe Legault, portfolio manager and financial analyst at Cote 100 portfolios. I believe that maintaining a good balance between growth stocks and defensive stocks at all times is an interesting formula. »

Senior director and portfolio manager of the North American Equity Division at IA Global Asset Management, David Caron, also believes that it is justified to add a defensive touch to the portfolio, not forgetting that the most cyclical securities are the first during economic recovery.

“We are in an environment where interest rates may start to fall and we may already be in a recession,” he notes. It may therefore be interesting to add these cyclical stocks given that some valuations have been completely destroyed in recent months. » In other words, yes to defensive securities, but not at the expense of bargains that can yield even more when all economic indicators are green.

Choose carefully

From one business cycle to the next, the so-called “defensive” sectors remain essentially the same. We certainly mention basic consumption (such as food), healthcare and public services (such as electricity supply). “For me, the defensive sector is a daily consumption,” sums up Stéphan Morin, Investment Advisor at Laurentian Bank Securities. Picking defensive stocks means investing in what I buy often. »

“These are stocks that are able to grow their earnings in an environment of recession or economic slowdown, or that can at least navigate the more difficult periods of the economic cycle well,” adds David Caron.

However, you should not get stuck in the defense sector with your eyes closed, warns Jean-Philippe Legault. “Some companies in a certain industry are more defensive than others,” he says. When it comes to consumers, for example, a toothpaste manufacturer is likely to be more defensive than a face cream company, even if they are associated with the same industry. “It’s never perfect. It highlights that when the economy slows down, these companies (which can be described as defensive) also have to face challenges that can vary from year to year. You have to look at each company individually to make a choice. »

To the three traditionally defensive sectors – consumer staples, healthcare and utilities – some specialists sometimes add others such as finance (banking or insurance), communications services (wireless, internet, etc.) or even technology. In the case of the latter sector, it is mainly the diversification of revenue sources and the impressive valuation of the web giants that provide this defensive touch, maintain David Caron and Jean-Philippe Legault. For example, companies like Alphabet or Apple should do very well, even if the economic context reduces advertising revenue or iPhone sales.

Several defensive sectors have had a tough year so far, at least in the United States. While the S&P 500 index of the New York Stock Exchange rose by 15% from the beginning of January to mid-November, securities of companies included in the index, which are part of the consumer sector of the base, fell by 6.5%, while securities of companies in the healthcare sector (-7.3 %) and utilities (-14.3%) fared even worse. Conversely, the communications services sector performed very well (+45.5%), as well as the technology sector (+47%), which benefited, among others, from the excellent results of companies such as Apple (AAPL, $191.45), Microsoft ( 377.44 USD) and Nvidia ($504.09).

Compromise

Defensive stocks can provide some sort of insurance to protect a portfolio in worse economic times, but their performance during the recovery phase of the economic cycle will rarely be as good as cyclical stocks such as those associated with discretionary consumption, for example.

“In a significant cyclical recovery, companies with a more defensive nature are not the ones that see the greatest growth in their sales, but growth remains interesting throughout the cycle,” estimates David Caron.

“In recent years, we’ve been used to big growth,” adds Stéphan Morin of Laurentian Bank Securities. In my opinion, we are entering a phase of deglobalization (with the repatriation of manufacturing activities close to the markets served), so growth expectations must be tempered in my opinion. » Clearly, he says, we should probably temporarily give up double-digit annual growth in terms of stock market returns. “In the current situation, I do not imagine strong growth in the financial markets. »

However, defensive securities — as with cyclical securities — require patience, points out National Bank Financial’s Steve Goulet. “My goal is always to evaluate stocks over a three-year period. That’s long enough to weather a recession or fashion shift, and long enough to benchmark against the competition. » Emphasizes that by choosing a defensive investment approach, the main goal is to prevent the portfolio from losing too much when the entire market loses weight.

A different approach

A classic defensive strategy is to choose securities that, after analyzing their sector of activity or their balance sheets, indicate that they will perform relatively well if things go wrong. But there is another approach, says Alexandre Hocquard, vice president and senior portfolio manager of the Systematic Investment Strategies team at Fiera Capital.

This second approach, which could be described as quantitative volatility management, is implemented in various defensive funds distributed by Financière Canoe but managed by Alexandre Hocquard and his colleague Nadi Rizko, CEO, Chief Investment Officer and Senior Portfolio Manager of PineStone Asset Management.

For each of these funds, Nadim Rizk selects the securities he considers to be the best, without worrying about their defensive nature. “Its task is primarily to create value above the benchmark of each fund,” explains Alexandre Hocquard. Then my job is to adjust the portfolio’s exposure to the stock market based on volatility without ever interfering with the securities it contains,” he explains. An investor who puts $1,000 into these mutual funds will always have $1,000 invested in the portfolio securities. »

“I am the risk manager, while my colleague is the added value manager of the funds we manage,” sums up the manager of Fiera Capital. My goal is for any defensive portfolio to suffer as few losses as possible in a bear market. In short, to protect your wallet. »

The secret ingredient: the futures contract

The key ingredient in this recipe? Futures contracts that represent an obligation to buy or sell an underlying asset—in this case, a stock index—on a maturity date. Or, to put it simply, financial instruments that allow you to “bet” on the rise or fall of the stock market.

Consider the case of a US stock fund. If Alexandre Hocquard anticipates an increase in volatility in the markets, he will sell futures contracts that are tied to the S&P 500, which means he will be “betting” that the index will fall. If the index falls as expected, the losses incurred by the securities in the portfolio will be largely offset by gains in the futures contracts.

“If we have signals that tell us that volatility is going to increase, we take what we call short positions to protect the portfolio. When we receive signals that volatility is about to ease, we exit those positions to restore full portfolio growth,” he says.

“I can take a position in the market, long or short, without having to move money. I only realize profits or losses, explains the expert. If I commit to $1 million, I have to prove that I have that amount, but I don’t have to move it around.”

All of the volatility assessment work that this practice relies on is facilitated by algorithms that analyze vast amounts of stock market data, such as the volume of trades made at different times of the day. Alexandre Hocquard uses the obtained results to make decisions, a bit like a manager of a baseball team who would analyze the performance of his players using advanced statistics.

“Currently, our algorithms are telling us that volatility will remain quite high in the coming months,” says the manager. This is characteristic of an environment of economic contraction. We risk a period when the stock markets will be shaken. »

“We don’t expect to have big losses over the course of two weeks. We expect a complicated market and losses in the longer term,” he says, referring to a period that could last three to nine months.

Leave your emotions aside

The method used by Alexandre Hocquard and his colleague ultimately aims to avoid panic movements driven by emotions.

So whether an investor chooses this method or conventional stock picking, the goal of both defensive approaches is the same: not to let impulse take over, even though it can be tempting to rearrange your portfolio in full swing during an economic storm. “I often say to stay invested according to your investor profile. It’s always the best advice we can give,” insists Stéphan Morin of Laurentian Bank Securities.

“The idea with defensive securities,” adds Steve Goulet of National Bank Financial, “is to make decisions that will work in the long term and be relatively protected in the short term. »