Some of my favourite FTSE 100 defensive shares have been looking lively. And I reckon the rise of general price inflation could have a lot to do with that.
Warren Buffett once told us an environment of high inflation favours businesses with pricing power and a low asset value on the balance sheet. To me, that sounds like good advice because such enterprises will likely be able to raise their selling prices to preserve profit margins. And they won’t need to spend too much on maintaining assets when costs are rising. So, with that theory in mind, I’m heading for some of the defensives.
Defensives versus cyclicals
To me, defensive stocks are those with steady underlying businesses that have resistance to general fluctuations in the economy. They tend to trade well, generate strong cash flow and keep up their shareholder dividends. And that’s whether the economy is booming, busting or moving sideways.
The other extreme is the cyclical stocks. They tend to suffer in economic slumps and downturns. And they often have a record of erratic revenue, earnings, cash flow and shareholder dividends. Meanwhile, their multi-year share price charts often look like a sketch of the mountains in the highlands of Scotland with many peaks and troughs.
My search for defensive businesses often takes me to sectors such as fast-moving branded consumer goods, information technology (IT), pharmaceuticals & healthcare, utilities, energy, technology and others. And when I’m looking for cyclical businesses it’s usually sectors such as banking & finance, mining, oil & gas companies, retailers, housebuilders & the wider construction industry, transportation, airlines, travel, and others.
6 portfolio candidates
The FTSE 100 has some prime candidates for this defensive, potentially inflation-fighting, investment strategy. For example, I’m keen on Unilever and Diageo in the branded, fast-moving consumer goods sector. And in pharmaceuticals, GlaxoSmithKline. While in the wider IT, software and technology space, I’m focusing on Experian, Relx and Sage.
However, such beasts rarely have a bargain valuation. And that’s because of often robust quality indicators — the market is usually quick to recognise such attributes by marking up valuations. For example, GlaxoSmithKline’s operating margin is running around 19%. But several are higher, such as Relx near 26% and Diageo above 29%. And percentages like that can be a strong clue that the underlying businesses could have a competitive advantage over their competitors.
A favourable economic environment
But buying quality doesn’t ensure a positive investment outcome. And the possibility of cycling valuations could cause me to lose money on these shares. Defensive stocks can fall in and out of favour with investors from time to time, even though the underlying businesses tend to be less cyclical than many others. And that sometimes causes valuations and share prices to cycle up and down.
But I’m keen on these stocks now because the general economic environment may help them attract investors. So, my guess is valuations and stock prices could cycle higher from where they are now. However, my assessment of the situation could prove to be wrong. Indeed, all shares carry risks. Nevertheless, I’m watching and buying stocks like these now because I also see them as good candidates for a long-term investment portfolio.