Thoughts on Defensive Strategies

In less than a week today, my defensive portfolio on Stockopedia will have its anniversary. During that period, it has returned 12%, compared with its benchmark index (FTSE350) , which is down 4%. A 16% outperformance - I can live with that.

Now, it could of course be that the market has favoured strong companies last year, and that I had merely chosen a fortuitous time to start the portfolio. During a tearaway bull market, it would be almost inevitable that a basket of conservative companies will underperform. However, I would like to draw on a couple of sources that give me encouragement to continue my portfolio, and refine the process.

My first source, is an investor who I like to follow on Motley Fool: F958B. I hope he doesn't read this blog. That would be embarassing. Anyway, he was relating how, following a defensive strategy, he has been able to generate a captial return of over 10% pa over the last decade. Given that the market has gone nowhere in the last decade, that's an impressive return. He does have gold in his portfolio, though.

My second source is Buffett. He once commented that even if you only knew 30 companies on the "big board", you could achieve a superior return. You would have to know what the 30 were, though.

It has made me think about how a defensive strategy might work. A good place to start would be to look at the Footsie, or FT350, and eject all the cyclicals. Take a chainsaw to the miners, banks, housebuilders, and so on. The ones that are left should be the fairly stable ones. Check their balance sheets, and reject the over-indebted. This gives you a much smaller list to look at. The good news is that I don't think that deep insights are required to understand the company. Everybody understands Tesco, right? No Mike Burry genius required there.

The next trick is to look for the ones that seem historically undervalued. This is where my skills as a programmer comes in handy, as I am able to automate statistical procedures. One test that I have been working on this week is to look for companies in which their PERs are in the P20 (bottom 20% of their historic range) or P80 (top 80% of the range). Once a month, one could perform a scan of the companies in the portfolio, and eject the ones that are overvalued and buy the ones that are undervalued. It's really quite simple. I am not saying it's the only or best test that you can do. You can slice-and-dice against a different statistic, if you like.

At the moment, pundits are wondering if the market is overvalued, fairly valued, or we've started the next bull run. One guy will say that the PERs are cheap, and another guy will say that on a PE 10 basis, it is expensive, and that the high margins that companies are experiencing now are likely to evaporate.

I have been doing some preliminary work on the stats, and I must say, they do look encouraging. Choosing companies more-or-less at random, I see that GRG (Greggs) the bakers is very very close to its P20 level, suggesting it is quite cheap. TSCO (Tesco) the supermarket is cheaper than it has ever been over the last decade. VOD (Vodafone) the mobile telecom company, is on a PER of 10.5, within a whisker of its P20 level of 10.0.

I reckon it should be relatively straightforward to select 10 low-risk companies that are fairly cheap. Provided your insight into the general safety of the company isn't worng, you would have good downside protection. By carefully rotating out stocks that are expensive, and buying in stocks that are cheap, I hope to improve the performance of my defensive portfolio further. I would be well pleased if I were able to generate a 10% capital return pa. I would probably generate an above-average income, too. This might not sound a lot to most people, but I would be quite happy with that return.

We shall see.