Defensive Equities: Finding Stability in an Unhinged World

Three powerful forces have unleashed a volatility storm in stock markets this year. But don’t give up on equities. Several strategies can be effectively deployed to help reduce risk and stay invested through the turbulence.

Hopes for an accelerated recovery from two pandemic years were dramatically dashed in early 2022. Instead, a sharp spike in inflation is threatening global economic growth. Russia’s invasion of Ukraine has made inflationary matters worse and added geopolitical risks. And as central banks raise interest rates, fears are growing that a miscalculation could tip the world economy into stagflation—and drag stock valuations even lower.

Stock markets are struggling to price in the effects on individual companies. As a result, the MSCI World Index has fallen by 12.0% this year through May 6, in local currency terms, while the S&P 500 has dropped by 13.1% over the same period. Sharp market swings have become commonplace, with the S&P 500 moving up or down by more than 1% on 44 trading days in just over four months.

With volatility expected to remain high, it may be tempting to reduce exposure to stocks. But by doing so, investors forfeit significant equity return potential. At some point, when the risks recede, equity markets can be expected to rebound.

In this environment, reducing equity risk is challenging—but it’s achievable with a disciplined approach. By focusing on quality stocks with stable trading patterns and attractive valuations, we believe equity portfolios can be created that are more resistant to volatility but capture long-term recovery potential.

Counter Inflation with Quality

Inflation fears are at the top of investors’ minds. Our research suggests that companies in the top quintile of US stocks based in our quality, stability and price (QSP) universe performed better than the broader market in past periods of extreme inflation (Display) in both rising and falling markets. During the OPEC oil embargo between 1972 and 1974, our QSP universe fell by 11%—much less than the S&P 500’s 16% decline. When inflation spiked after the Iranian revolution from 1977 to 1980, QSP stocks advanced by 11.3% while the market was flat.

When prices are rising fast, companies face a variety of pressures on both the cost and income sides of their businesses. We believe that high-quality companies, with strong and consistent cash flows, have more ways to protect their margins even as input costs increase. Pricing power—an important quality feature in any market—is an essential attribute; it allows companies to push prices up without worrying about taking a hit to demand.

Measures of profitability, such as return on assets or return on invested capital, are important quality indicators and strong predictors of future earnings power. Similarly, companies that demonstrate capital discipline will be prized in a rising rate environment. Companies that we call quality compounders have successful business models and sustainable earnings, backed by good capital stewardship and positive ESG behavior. Intangible assets such as brands, culture, R&D and patents are also valuable features, particularly in times of stress. These attributes support compounding earnings gains from consistent growth drivers through market cycles.

Finding Stability in More Predictable Earnings

Protecting portfolios from geopolitical tensions is tough. Risks such as the war in Ukraine or election outcomes, are inherently unpredictable and may have surprising effects on markets. Predicting geopolitical outcomes isn’t a prudent investing strategy, in our view. However, we can focus on stocks that have more more predictable earnings patterns than others, even in difficult times with limited visibility. Over time, our research suggests that companies like these tend to outperform the market, with better risk characteristics, lending stability to a portfolio.

Stable companies come in many forms—and are often not typical defensive stocks. Take the technology sector, which was never really considered a defensive part of the market. Yet today, some tech companies provide services that are so integral to the global data infrastructure that their earnings and performance patterns are as dependable as utilities—a more traditional defensive play. Technology enablers are an important piece of the puzzle, as they provide essential hardware, software and services to address current macroeconomic and geopolitical stresses. In contrast, hypergrowth technology stocks don’t have defensive characteristics, and many have indeed sold off sharply this year.

Valuation Focus Helps Reduce Risk

Stable stocks won’t get the job done if they are too expensive. That’s why it’s important to verify that stocks trade at relatively attractive valuations when constructing a defensive equity portfolio. Today, when rising interest rates can induce valuation risk, maintaining price discipline improves the chances of success for a lower-volatility equity portfolio.

Focusing on these attributes is the key to creating an equity portfolio that will fall less than the market in a downturn. More moderate declines make it easier to recover losses faster when the market rebounds. In times like these, when the outlook is so cloudy, it’s hard to imagine when the inflection point will come. Staying in a carefully curated portfolio of stable stocks of quality companies can help ensure that an investor will benefit from better times ahead.