Hang on to defensive stocks

Defensive stocks are riding high on a wave of panic. But that's no reason to ditch them just yet, says Merryn Somerset Webb.

Is there a bubble in dividend-paying defensive stocks? We've asked the question here before we've been recommending them for four years or so, so we need to monitor how they're doing. An article in The Wall Street Journal this week outlined just how popular they are.

Since mid-April, telecoms, utilities, healthcare and consumer staples are the only S&P sectors to have risen. Telecoms are up 14%; utilities 7.5%. Meanwhile, the S&P 500 has fallen 1.2%. "Defensive stocks are trading near a decade-high relative to their more economically sensitive peers" if you look at their price/earnings ratios, says Adam Parker of Morgan Stanley.

Investors are paying around 25% more for stocks that pay dividends than for stocks that don't. Add that to the fact that US investors have poured a net $16bn into equity income funds since the start of the year (with inflows still rising), and it's beginning to look like a crowded trade.

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Price isn't the only risk. If you're holding US-based defensives you may worry about the coming rise in US tax rates. If nothing is done about the so-called fiscal cliff, the top tax rate on dividends in the States will rise from 15% to 43.4%. That will make equity income funds look less attractive. Then there is growing stock-specific risk and political risk.

You can't open a paper or turn on the BBC without someone pointing out that the real money in Britain, America and Europe is on corporate balance sheets. And too many people suggest those corporations don't deserve to keep it. There's already a tax-the-cash' lobby in the States, and in Britain some blogs are joining the bandwagon. Here's Taxresearch.org.uk: "let's tax them and put the money to use in the public sector".

This isn't top of my worry list for now (the government seems more keen to cut corporate taxes than anything else), but it can't be ignored. As we have noted before, cash-strapped governments go where the money is.

So should you stay in your dividend-paying, defensive stocks? The answer is probably yes. Investors are buying them for good reason: it's hard to see where else you can have confidence in preserving your capital's long-term value and getting an income. They'll be left behind when the market turns (which it will) and cheaper cyclical stocks soar. But history tells us that defensive shareholders will be the winners in the long run.

That said, to mitigate the risk that the government helps itself to some of your cash, you might also consider buying the GCP Infrastructure Investment Trust (LSE: GCP). It trades at a 7% premium to its net asset value, but still yields 6.3%. How? From holding PFI debt (which is effectively backed by the government). That means that if you hold it you not only get a high income but you can see that income as a small part of your misspent tax money returned to you.

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.