With the share market experiencing volatility in the new year, defensive stocks are in greater demand from investors keen to shield their portfolio from a possible correction and any bursting of the bubble in share prices.

Huge bond purchases by the US Federal Reserve and quantitative easing in developed markets worldwide have driven interest rates to historically low levels. As a result, many share prices are inflated, raising the risk of a correction, according to experts.

Yet some stocks will weather any sell-off better than others, including those with defensive businesses and strong balance sheets, which are tipped to do well irrespective of the economic climate.

“One of the greatest forms of protection for investors in down-turn environments is balance sheet strength and this is a key component in our investment process which assist greatly in delivering stable through-cycle returns,” says Jan De Vos, portfolio manager, Resolution Capital Real Assets Fund.

The healthcare sector, including CSL and ResMed, is generally considered defensive as long-term demand for health products and services is relatively inelastic and based on need, says Morningstar healthcare analyst, Shane Ponraj.

With COVID-19 well controlled in Australia, Ramsay Health Care’s market-leading hospital business is another example of a defensive stock, set to enjoy a strong recovery over coming months, according to Jun Bei Liu, lead portfolio manager, Tribeca Investment Partners.

“Even in the event of further outbreaks, the proven ability of state governments to quickly control the spread should ensure there will be little impact on the hospital system,” Liu says.

“A robust rise in patient volumes should support a rapid recovery in margins—even allowing for the increase costs caused by new COVID-19 protocols and social distancing—resulting in a dramatic recovery in group profits.

“We see limited risk to the recovery given the pent-up demand, with surgery waiting lists up sharply compared to pre-pandemic levels.”

However, investors must keep in mind the inflated share prices of health care companies. “Healthcare share prices in general extended significantly in 2020 due to the pandemic, taking most of our [healthcare] coverage into overvalued territory,” says Morningstar’s Ponraj.

“While CSL typically carries a higher beta than ResMed given it is the third largest stock on the ASX by market capitalisation, it currently trades 9 per cent above our fair value estimate, compared to ResMed, trading 40 per cent above.

“We view ResMed as being significantly more overvalued by comparison, as we expect its pandemic-related ventilator sales to trail off and sleep apnoea diagnosis rates to remain under pressure,” he says.

Switching to infrastructure

Morningstar’s Global Equity Best Ideas list includes one Australian stock considered to be defensive, Spark Infrastructure Group. The list is a monthly compilation of stock ideas chosen by Morningstar’s global equity research team.

Infrastructure assets such as electricity utilities typically deliver reliable income streams even during a downturn and through various interest rate environments.

According to Morningstar’s Global Equity Best Ideas Report, Spark Infrastructure trades at a discount to its fair value estimate.

“Despite lacking a moat, Spark is a defensive company. It has headwinds from falling regulated returns, but those are well understood and, we believe, priced in. We forecast a sustainable 2021 distribution yield of nearly 6 per cent, partly franked.

“Spark is relatively well insulated from the economy as the regulatory system should see network tariffs increase to offset any weakening of electricity demand caused by COVID-19,” says the Morningstar report.

Resolution Capital’s De Vos says there are very few listed Australian companies which provide more predictable revenue than Spark.

“Spark owns critical infrastructure assets including poles and wires and high voltage power lines that effectively transport power from the generation sources to consumers. The decentralisation and decarbonisation of electricity generation plays into the hands of Spark.

“As coal-fired power plants are retired and replaced with new renewable power sources, these renewables require energy transmission infrastructure to be built to integrate them into the electricity grid, providing a growth opportunity for both AusNet and Spark.”

Another example is Arena REIT, according to De Vos, which operates in the childcare and healthcare sectors.

“An example of a business we believe has strong defensive characteristics and could provide portfolio strength in a down-turn is social infrastructure property group, Arena REIT. Arena is one of the biggest childcare landlords in Australia. Importantly it is a triple-net REIT, meaning the tenant is responsible for the properties upkeep which improves the REITs cash conversion,” he says.

“Arena has a very long average lease length of around 14 years, providing a very predictable income stream. Even during COVID its dividends grew 4 per cent. Its tenants provide an essential service, which was recognised by the government during the pandemic lockdown.”

Dougal Maple-Brown, head of Australian equities at Maple-Brown Abbott, also names Metcash and the packaging company Amcor as reasonably priced defensive stocks.

“Unfortunately, it is far easier to identify parts of the market that look particularly vulnerable,” Maple-Brown says.

He lists some technology or hyper-growth stocks that collectively trade on prices around 100 times earnings, “almost twice the multiple they traded on a year ago look. We would suggest these types of stocks would be particularly vulnerable to a sell-off,” he says. The names he refers to include: Afterpay, Altium, WiseTech Global, Appen, Carsales.com, NEXTDC, Domain, Xero, Seek and REA Group.

Australian tech stock valuations beggar belief

Similar valuation trends globally

a chart showing Australian tech stock valuations

Source: FactSet, data as of December 2020

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