I am currently deep in the hunt for a new Bull List addition. However, as you can probably imagine, it is becoming increasingly hard to identify stocks that provide long-term potential at current valuations.
Yes, I could highlight numerous stocks I expect to perform well over the next year or so, but ultimately, that is not my goal. There are very few stocks on the market at this point in time that provide a reasonable margin of safety. I’m sure I will find some in my endeavours over the next few weeks here, but thus far, I haven’t found anything.
This leads me to a topic I’ve been asked about a ton as of late, and that is shifting to more defensive positions in light of current market valuations.
This is a popular strategy among many investors to deviate away from adding to large growth positions and instead allocate capital to defensive companies that are likely to go through smaller drawdowns in the event of market volatility.
I’m going to dig into the intricacies of the strategy, why I think “rotation” strategies for retail investors are generally poor, and what you could look to do instead.
Of note, I didn’t make any moves in my portfolio this week, as I am waiting for my Norbert’s Gambit transactions to go through.
What Makes a Stock “Defensive” in the First Place?
When I call a stock defensive, I mean it’s built to hold up when the economy slows or market volatility rears its ugly head. These businesses have stable earnings and predictable cash flow.
A lot of people associate defensive stocks with poor returns. This is not the case.
Look to a company like Foundational Stock Waste Connections, one I would view as particularly defensive. Before its recent drawdown, which is to be expected as the markets become euphoric (defensive stocks often draw down in an environment like this), it was a long-term outperformer of the S&P 500.
Let’s look to another example. Canadian Foundational Stock Loblaw. 254% returns over the last half-decade. Not bad for a “boring” grocery company.
Defensive stocks sell products or services people keep buying, whether times are good or bad. Think electricity, toothpaste, groceries, or, as I mentioned, waste disposal. Demand doesn’t really swing with the economy.
Typically, during large bull markets, defensive stocks will lose their allure due to their lower volatility and slow-moving stock prices.
Defensive stocks tend to keep revenue steady in recessions, even if they lag during expansions.
The core appeal of defensive stocks is pretty straightforward: they sell stuff people need, no matter what’s going on in the economy. Consumer staples, utilities, and healthcare companies keep cash flow steady even if people cut back on extras.
That reliability draws investors when things get uncertain. However, as I mentioned at the start of the article, trying to time these things and rotate into these holdings during periods of volatility is often going to lead investors to underperform. I’ll fill you in on what could be a potentially better strategy later in this newsletter.
How Did Defensive Stocks Perform During the 2022 Volatility?
The 2022–2023 stretch really tested every asset class. What changed the playbook here was primarily rapid inflation and hyper-aggressive rate hikes.
Defensive sectors like consumer staples and healthcare held up better than most, but the story wasn’t the same across the board. Consumer staples managed steady returns because companies could pass higher costs to customers without losing much demand.
However, it is not as cut and dry for all defensive stocks in 2022. For example, utilities are defensive in nature. However, the environment was exceptionally difficult for them, and they were certainly not among a basket of defensive stocks that performed well.
On paper, they’re defensive. In reality, their heavy debt loads made them vulnerable to rising interest rates.
Rate sensitivity capped their upside, even when investors looked for defensive stocks to shelter in. That’s the catch with defensive holdings. Each one of them can perform differently, depending on what has caused the economic shock.
I’ve attached a chart below that highlights two funds that hold a wide variety of “defensive” stocks. These are low-volatility funds, which typically hold baskets of stocks that are defensive in nature. As you can see, both of these funds outperformed the S&P 500 and the NASDAQ substantially during the drawdowns of 2022.
Why Are Investors Considering the Shift to Defensive Holdings?
As I’ve mentioned previously in the newsletter, I’ve gotten quite a few requests from people who are concerned about the current market. There is good reason to be concerned, as speculation is at some of the highest levels we’ve witnessed over the last 30 years.
I just want to preface this by stating that I have never been a doomsday-type of investor. My time horizon is long, and in general, it is easy to be bullish over that timeframe.
For this reason, I never really structure my portfolio to be ultra-defensive in nature and “prepare for the worst.” I am 100% equity and will remain 100% equity. Whatever your allocations are, depending on your time horizon, risk tolerance, and investment goals, they might be different.
We are now in an environment where margin debt has skyrocketed to all-time highs, penny stocks and unprofitable stocks are seeing some of the largest dollar volume activity in decades, and insiders are selling stocks at nearly 5 times the pace they’re buying them.
I’ve attached an image above of the situations in which margin debt quickly accelerates. The blue line is the margin debt, while the red line is the S&P 500’s returns.
In practically all instances over the last 30 years, there has been a significant correction that follows.
In addition to this, I’ve attached a chart below of Goldman Sachs’ Speculative Trading Indicator. In a nutshell, what this is saying is that penny stock, expensive valuations, and unprofitable stock trading volumes are in the 98%, 96%, and 85% percentiles.
In actual numbers, what this means is that out of the 420 months since 1990, there have only been nine months where penny stocks have shown higher trading volumes than today.
While none of these indicators guarantee an imminent correction, they do signal that risk is elevated. I know, as investors, none of us like to look at this stuff. It tends to cause emotions to come up, and in some instances, panic. However, I think acknowledging the fact that we are in an extensive “risk on” market can actually ease emotions, because we know there is the potential for heavy volatility.
For me, this isn’t a call to go all-cash or panic. It’s a reminder to check allocations, make sure positions align with your goals, and be mentally prepared for volatility. Long-term investors win by staying the course, and staying the course does require some acknowledgment of the situation.
Risks of Going Too Defensive Too Early, or Defensive At All
I’ve seen plenty of pundits advocate for crowding into defensive stocks before the data confirms a downturn. The problem is timing.
If you rotate too early, you risk locking yourself into lower-return sectors while the broader market keeps climbing.
Defensive sectors like healthcare, utilities, and consumer staples tend to lag in the early stages of a recovery. Growth and cyclical companies usually lead when sentiment turns up.
Look to Bull List stock BRP for a prime example of this. It’s up over 100%~ in just 4 months.
If you overweight defensives during this phase, you’ll probably underperform the broader market. That gap adds up fast if the cycle stretches longer than expected. Look to the chart below. We can see that the low volatility S&P 500 ETF outperformed the S&P by a wide margin in 2022.
However, if investors waited too long to cycle into defensives, which is usually the case as they need to be accumulated before the drawdown occurs, not during, they underperformed extensively over the last few years.
Valuation is another worry. When too many investors pile into the same “safe” names, you get higher valuations. We witnessed this over the last few years with a defensive name like Waste Connections. It is now going through a drawdown as the markets continue to climb upwards.
If you’ve gone all-in on defensives, you might find yourself competing with safer fixed-income products offering similar returns with less volatility.
False recession signals are another trap. Markets often price in slowdowns that never really happen. The best economists on the planet are terrible at predicting the economy. So, imagine how bad retail investors are.
If you shift too defensively on a misread in the economy, you risk missing upside in sectors that thrive when growth steadies.
This Is Precisely Why I Tend to Keep Defensive Holdings in My Portfolio at All Times, Instead of Trying to Time It
Diversification cushions both my downside and recovery. Sure, my returns are not as sky high during markets like this, but they’re also not as ugly when the market decides to correct.
I am an investor who would rather try to achieve slightly above average returns for an extended period of time, rather than trying to grab 20%, 30%, 40%~ returns in markets like this and then try to rotate out of those holdings when the time is right.
Because when the markets are this elevated, you never really know when the bottom will fall out. Hitting consistent singles and doubles generally works out better for investors rather than trying to consistently hit home runs.
Eventually, you will get a period where all you can do is strike out.
So, Is Going “Defensive” a Good Idea?
I see the case for defensive positioning in 2025. If you are thinking this is something you’d like to do, I don’t blame you at all.
But, I also believe that every investor’s portfolio should be structured in a way that there is really no need to “rotate” into defensive holdings. Just hold them throughout the cycles. Accept the idea that these holdings might not provide the best returns during large upcycles, but that they are there as a type of “insurance” against market volatility.
Not immune to volatility. Don’t make that mistake. But generally, they will exhibit lower volatility.
A well-diversified portfolio contains a well-rounded basket of stocks that doesn’t tilt too heavily in any one particular direction.
But here is an important point:
How much that “tilt” is depends on your overall risk tolerance and time horizon. At this point in time, I have a multi-decade time horizon. So my defensive tilt is small. But I still hold numerous defensive stocks. Berkshire, Home Depot, Lockheed Martin, Fortis, to name a few.
Look no further than the Foundational Stock lists. On the Canadian end, the vast majority of these stocks are defensive in nature. These are precisely why I create these lists each and every year.
And what I’ve noticed over the years is they largely get ignored during euphoric markets. But it is during times of volatility that they typically provide the most benefit.
