Questor special: FTSE 100 defensive shares for a market panic

Defensive shares
Questor says HOLD

NOT all shares are falling as the FTSE 100 slumps into a correction. A glance around the markets reveals that there are a few safe havens during a sell-off; a good reminder of the benefits of diversification.

The FTSE 100 index of leading shares has now fallen almost 10pc this year. However, defensive equities have been on the rise over the same time.

When economic growth falters and a financial crisis hits the markets, investors will be better able to ride out the storm by holding shares in utility, tobacco and pharmaceutical companies.

The companies in these sectors are not as exposed to the wild swings in the market – they provide services and goods that people need to buy whatever the economic weather. As an added benefit they usually have a track record of paying dividends.

Unsurprisingly, defensive shares have outperformed the market over the past month.

The starting point for thinking about defensive plays has to be the utility sector.

The index of utility companies, which are backed up by vital infrastructure assets, has increased by 1.3pc so far this year.

Right now the sector is enjoying a Goldilocks macroeconomic moment: steady inflation is supporting price increases and record low interest rates are making debt easier to service. This is important for the highly leveraged infrastructure groups.

These factors have been noticed by some of the world’s richest investors. Northumbrian Water Group was taken private by Hong Kong tycoon Li Ka-shing in 2011, at a premium of 25pc to the value of the underlying infrastructure assets at the time. Severn Trent was also the target of a £22-per-share takeover bid last year. The Long River consortium was made up of Borealis, the Canadian infrastructure company, the Kuwait Investment Office and the UK’s Universities Superannuation Scheme.

Severn Trent reported steady revenue and profit performance in the most recent results. The shares are trading on 20.8 times forecast earnings and offer a yield of 4.5pc.

Severn Trent has paid a dividend that has increased at RPI (a measure of inflation) plus 3pc for the past five years; however, the new settlement with the regulator looks set to be much tougher and investors are waiting for guidance on the new dividend policy, which is due on November 25.

Shares in the water sector are driven on a five-year regulatory cycle. The water sector regulator Ofwat is currently in negotiations to agree the prices from April 2015 to 2020. There is still disagreement between the two parties and this creates risk for shareholders. The regulator could make the industry much less profitable by forcing it to cut prices. The final decision will come on December 12, so, if you are thinking about investing in UK water utilities, it could be a good idea to wait until after that.

United Utilities is one of the steadiest operators in the sector and it said it would stick with its annual dividend growth of 2pc above the rate of RPI inflation until at least 2015. The shares are a classic defensive play as United Utilities is the largest listed water utility in the country.

Shares in United Utilities are up 18.6pc so far this year and trade on 17.5 times forecast earnings with a forecast dividend yield of 4.7pc.

Pennon is not your average utility company. It combines South West Water, a profitable and stable water utility, and Viridor, a loss-making and hugely capital-intensive landfill and recycling group. Quite the odd couple. The shares are currently trading on 21 times forecast earnings and offer a 4.2pc dividend yield.

Shares in the UK power sector are cheaper due to the uncertainty about energy policy and fears over Labour plans to freeze or even cut prices. SSE is one of the UK’s big six energy providers and was formerly known as Scottish and Southern. Based in Perth, it was boosted by Scotland voting No to independence. This means it will retain millions of pounds in UK Government support for its renewable energy projects.

The shares trade on 12 times forecast earnings and offer a 6pc dividend yield. The dividends are looking exposed though as they are only covered 1.3 times by earnings and are currently being paid out of debt.

The UK’s largest listed utility company, National Grid, reported a steady profit performance in its annual results, an encouraging start following its new eight-year settlement with the energy regulator. The shares remain a good long term bet.

The tobacco sector is another perennial defensive favourite. Its customers are addicted to its products and therefore continue to buy them even when cutting back in other areas. This ensures steady revenues. Tobacco companies are managing to fight off falling sales by steadily increasing prices and keeping tight control of costs. Imperial Tobacco and British American Tobacco remain solid defensive favourites. The shares have risen 7.1pc and 4.6pc respectively and pay a handy dividend income of about 5pc. We would recommend them as a core holding in any investment portfolio.

The pharmaceutical sector has been more of a mixed bag for investors this year. While AstraZeneca has been boosted by bid interest and developments on new drugs, rival GaxoSmithKline has been hit hard by bribery allegations and a profit warning. AstraZeneca shares are up 17.7pc so far this year and Glaxo are down 17.7pc over the same period.

Shire has also been subject to a takeover bid, which looks to have unravelled, but the shares are still up more than 28.8pc so far this year.

Consumer goods giants Reckitt Benckiser and Unilever have been hit by a slowdown in emerging markets, but their cleaning products still have steady demand and they remain good defensive options. Reckitt Benckiser is up 4.9pc this year compared with Unilever, which is down 1.3pc.

A sharp market correction is always shocking for investors but those holding a well-balanced portfolio will be less worried than those who are over-exposed to more cyclical sectors.