Three out-of-favour defensive stocks

Professional investor Philip Matthews favours shares that missed out in the past year's rally, despite posting positive earnings and offering high dividend yields. So he has repositioned his portfolio to include unfashionable but solid defensive companies. Here, he picks three to buy now.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week: Philip Matthews, manager of the Jupiter Income and Growth Fund.

After a period in which the market has been favouring cyclical firms, I've repositioned my portfolio. Some of the more cyclical holdings, such as IMI and Invensys, have been removed and I've reinvested the proceeds in firms with defensive earnings in sectors that have been out of favour. I like shares that have lagged the past year's rally, despite seeing positive earnings flows and offering high dividend yields.

One such stock is Lloyd's of London insurance firm Beazley (LSE: BEZ). Unlike other similar firms, its underwriting business isn't as exposed to pure catastrophe risks. That's down to a focus on lower-risk business such as liability policies for architects. With a valuation at the bottom end of its historical trading range, it trades on a discount to its forecast net tangible assets. That's despite the fact that it has demonstrated it can generate healthy returns. The stock is trading on a price/earnings ratio (p/e) of just over five times future earnings and offers a dividend yield above 6%. The market seems reluctant to invest in the sector against a headwind of falling insurance rates. Yet Beazley is well reserved and the shares represent a reasonable hedge should interest rates begin to rise again.

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I've also been buying bus and rail firm Firstgroup (LSE: FGP). It's fallen out of favour with the market mainly as a result of earnings downgrades relating to a US school-bus business it bought in 2007. Following the credit crunch, individual US state budgets have been squeezed and revenues for this division have come under pressure. The British rail business has also seen a drop-off in profitability. But I believe profit forecasts have now bottomed and the valuation looks attractive.

Firstgroup's core British bus business is relatively defensive and profits have hit a trough from which they can now grow. The stock is trading on a p/e multiple of nine times next year's earnings and is yielding more than 5%. Profits should grow from here and the dividend yield looks stable.

Many investors have avoided construction in recent times due mainly to the sector's exposure to the domestic economy. There are, though, some specific stock opportunities. Consulting engineer WSP (LSE: WSH) provides civil engineering designs for all areas of the sector, from retail offices to hospitals, roads and railways. With construction hit hard during the recession as building projects fell away, the firm's valuation remains depressed. That's down to concerns about a drop in government spending. However, its relatively low exposure to UK government spending and the growing international and private-sector nature of its profits could mean earnings estimates rise from their current conservative levels.

WSP's balance sheet is in good shape, the business is cash generative and it has a dividend yield above 5%. This is well covered by profits, which have already seen a 30% drop. I started buying the stock when it was priced at £2.80. Since then we have received a 10p per share dividend from the company and its share price has moved up to £3.45. Yet nothing has changed in analysts' estimates. The firm's dividend looks stable and well covered.

I would also expect capital growth as the outlook for profits becomes less bearish and the shares are re-rated from their current depressed earnings multiple.