At the time of writing talks between the Greek government and its creditors were in deadlock ahead of a 30 June debt repayment deadline. Even if an agreement is brokered, any deal is likely to offer short-term resolution at best, essentially kicking the risk of default and a Greek exit from the eurozone down the road.

This is not the only threat to equity markets for the remainder of 2015. You must consider the prospect of the US Federal Reserve (Fed) increasing interest rates more aggressively than expected, heightened by Fed governor Jerome Powell indicating (23 Jun) there may be two rate hikes before the end of the year.

At times of market volatility investors tend to opt for defensives - solid, low-volatility, low-risk stocks which are relatively less exposed to fluctuations in the economic and stock market cycle. Because of their status as bond proxies - essentially a higher yielding alternative to bonds after that asset class became over-owned - traditional defensive stocks are particularly vulnerable to the looming increase in interest rates. And with investors queuing up to buy the same old shares, equity valuations have also got somewhat out of kilter with reality.

To help you come up with some alternative ‘defensive’ ideas to ride out future bumps in the road Shares has, with the help of Sharescope, filtered the FTSE All-Share to arrive at a selection of stocks.

To root out so-called ‘expensive defensives’, our search stipulates a prospective price to earnings ratio of 17 or less and a dividend yield of at least 2%. Our desired stocks must also have a beta relative to the FTSE All-Share of less than 0.75.

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The results from our screening exercise includes life insurer Chesnara (CSN), small cap telecoms play KCOM (KCOM), bingo hall operator Rank (RNK) and niche consumer and motor finance provider S&U (SUS).

Partly because it is a bit of an outlier - i.e. doesn’t sit in a traditionally defensive sector - we also go through the attributes of classic defensive counter Dignity (DTY). Although the shares presently do not meet our desired PE ratio ceiling and dividend yield floor, there’s still good reason to add this stock to your portfolio as we discuss later in the article. We also take a look at low volatility exchange-traded products and consider the merits of iShares MSCI World Minimum Volatility (MVOL).

What is a defensive?

All economies experience recurring and fluctuating levels of activity over a period of time, with the five main stages of the business cycle widely accepted as running as follows: growth, peak, recession, trough and recovery.

The business cycle is usually replicated with the stock market going up when the economy is growing and going down when it is contracting. Different types of stocks tend to perform well at different points in this cycle. At times of economic or market uncertainty ‘defensive’ stocks typically come to the fore.

What exactly do we mean when we describe a stock as defensive? The main clue to its meaning is in the name - defensives offer investors a defence against falling markets because they do not fall as far or as fast as other stocks. Ideally, they wouldn’t fall at all - or, at best, they increase in value as investors seek solace from market volatility and switch from speculative to defensive businesses.

Usually they have been found in sectors and industries such as utilities, consumer goods, pharmaceuticals and tobacco. What they have in common are relatively stable revenue streams, with demand for their products and services largely unaffected by the state of the wider economy.

For this reason they are sometimes also known as ‘non-cyclical’ stocks and it is important to remember that while they are spared the full impact of recession they will generally not experience a significant upswing in demand when the economy recovers.

As such they are in direct contrast to cyclical businesses including travel operators such as Thomas Cook (TCG) or fashion retailers such as French Connection (FCCN), which see spending on their goods and services increase rapidly when the economy is booming, and consumers feel confident about investing in luxuries like foreign holidays and new clothes, but suffer a substantial fall in demand when the economy is weak.

Because defensives have consistent revenues, profits and cash flow they are usually reliable dividend payers - offering their shareholders the comfort of regular income. In order to demonstrate how defensive stocks outperform when markets are falling it is worth looking at a historical example. Shares in consumer goods giant Unilever (ULVR) increased in value by 24.1% through the 2008/9 recession which in the UK ran from the third quarter of 2008 through to the fourth quarter of 2009. By comparison the FTSE All-Share index fell 7.2% over the same timeframe. Unilever manufactures everyday brands such as Lynx, Domestos and PG Tips and demand for these household staples is more resistant to economic downturn.

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Historically utility companies, like United Utilities (UU.) or SSE (SSE), have been classic examples of defensives. Their profits, at least in part, are dictated by regulators which stipulate what they can charge for the provision of gas, water and electricity and even how much they must spend on updating their existing infrastructure. The increasing threat of regulation and greater sensitivity to interest rates has somewhat undermined these defensive credentials of late.

As we recently discussed, (see Agenda, Shares, 4 Jun) analysts at investment bank Exane BNP Paribas make the case for favouring telecommunications stocks over utilities at the defensive end of the investment spectrum, believing that recent outperformance of the former will continue through the rest of 2015 and probably beyond.

According to numbers crunched by the investment bank’s analysts, pan-European telcos have delivered a 17% return year-to-date versus 7% for the utilities sector. Three factors sit behind Exane’s conclusion; sensitivity to potential rising interest rates, leverage to domestic macro recovery, and bottom-up pricing power. Exane’s research also shows how the premium utility stocks enjoyed over their telecom counterparts has all but been wiped out. ‘Utilities used to trade at a 20% premium to Telcos on EV/EBITDA (enterprise value to earnings before interest, tax, depreciation and amortisation), but multiples are now in line, and have been close since mid-2013.’

The traditional outperformance of defensive stocks during market turmoil looks at risk of breaking down - and not just in the utilities space. A piece of thematic research by Morgan Stanley published on 22 June noted that European defensive stocks underperformed in the correction seen since mid-April - the first time this sub-set of the market had underperformed in falling markets since 1986.

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Analyst Graham Secker and his team write: ‘The rise in global bond yields is the key driver behind these unusual performance patterns, in our view. With bond yields likely to move higher over the medium term, reflecting rising inflation and the impending first Fed rate hike, the question of how to be defensive is likely to remain relevant for more cautious investors.’

The accompanying table shows a list of European stocks identified by Secker and co - each with a beta of less than one and a flat or positive correlation to bond yields.

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Perfect stocks

Finding companies which will stand up better in a market slump is one thing but the holy grail for investors is to identify stocks which can achieve long-term growth however much others are struggling. There are five main ingredients to this kind of enduring success:

• An experienced management team that lays down and executes a strategy designed to achieve organic growth.

• Pricing power (the ability of a company to increase prices for its goods and services without unduly impacting demand - often reliant on the strength of its brand or brands).

• High operating margins (representing the proportion of revenues retained as profits).

• Strong cash flow to fund the business and pay dividends.

• A sound balance sheet.

Stocks with these attributes are ones to truly own over the long-term rather than rent during periods of short-term volatility. The selections in this article may not be completely recession proof but they should nonetheless offer some ballast to your portfolio when the market is in tumult.

Smart beta

Smart beta, also known as alternatively-weighed exchange traded funds (ETFs), provide investors with exposure to particular investment themes or strategic exposure to lower volatility stocks rather than simply following a market cap-weighted index. Most equity ETFs are currently market-cap weighted and proportionally feature stocks according to their importance in a given index. Each 1% price movement at those firms with the highest market values therefore moves the underlying benchmark and thus the ETF by more than an equivalent rise or fall at the smallest companies. By using smart-beta products, investors can tilt portfolios toward firms with certain characteristics, give their holdings a certain bias or neutralise the undue influence of certain stocks. A popular sub-set within this space are low volatility ETFs.

iShares MSCI World Minimum Volatility (MVOL) $34.19

The minimum volatility strategy behind the ETF aims to select a subset of constituents from the parent index - in this case MSCI World - with the lowest absolute volatility of returns. For a smart beta product it is relatively inexpensive with a total expense ratio of 0.3% and it appears to track the benchmark pretty efficiently. A total return of 13.08% in the period between 31 March 2014 and 31 March 2015 is just eight basis points behind said benchmark.

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A heavy bias towards defensive sectors such as health care and consumer staples as well as its substantial exposure stateside (60.8%) means it could see its performance hit by the anticipated upcoming hike in US interest rates. The product therefore makes sense as a building block in a long-term portfolio but investors should be aware of the risks to the stocks which sit within it from rising rates. (TS)

You’d Beta believe it

Distribution specialist Connect (CNCT) and equipment hire outfit VP (VP.) both have low beta readings that left us scratching our heads. VP is ranked the eighth-lowest beta stock in the list produced by Sharescope while Connect is eleventh.

Operating in cyclical industries, their low beta readings don’t appear to make sense. Investors can get an idea of why beta throws up the occasional red herring by considering how the number is calculated:

BETA=

VOLATILITY OF STOCK X CORRELATION OF STOCK

VOLATILITY OF MARKET

Beta reflects the volatility of a stock and its correlation with the market, as measured by daily changes in price. Stocks like Connect and VP, which are smaller and less liquid than their Main Market counterparts, may not move at all when the FTSE All-Share is up or down sharply because of a lack of trading in their shares.

When the stocks do move, they will tend to move around in larger increments - and this is reflected by relatively large volatility numbers for both stocks.

Connect, tied to a large extent to its news and magazines distribution business, is likely to be impacted by cyclicality in newspaper sales because it earns a percentage of the cover price of publications it distributes.

Performance of equipment hire stocks like VP tend to be closely tied to the economic outlook because their services are used in the construction and infrastructure industries.

We would expect VP to be more insulated from economic shocks than its peers because its equipment tends to be hired out to a less cyclical customer base for mission-critical projects like energy transmission maintenance and rail repairs. But we would not rate it among the most defensive stocks on the FTSE All-Share. (WC)

The classic defensive

Dignity (DTY) £21.16

Market Cap: £1.03 billion

Prospective PE Dec 2015: 21.8

Prospective dividend yield: 1%

Beta: 0.28

Positive sentiment towards Sutton Coldfield-headquartered Dignity (DTY) reflects the attractions of its industry consolidation story as well as the proven defensive characteristics of the UK’s only listed provider of funeral services.

Shares has long-championed Dignity’s defensive attractions, derived from the non-discretionary nature of the day-to-day business. The £1.03 billion cap offers a play on the first of life’s two oft-quoted certainties, death and taxes. It draws resilience from low customer price elasticity, the pricing power of the industry, as well as the company’s strongly cash-generative business model.

DIGNITY’S KEY DEFENSIVE ATTRIBUTES

• Predictable industry demand

• Low customer price elasticity

• High cash conversion

• Progressive dividend/scope for additional capital returns

Dignity’s operations are managed across three divisions: funerals, the main profit engine; crematoria; and pre-arranged funeral plans. Its key competitive strengths include exceptional levels of client service as well as its geographic reach, the latter delivering diversification via a portfolio effect. National coverage also means Dignity can look to make acquisitions anywhere in the country and sell pre-arranged funeral plans anywhere in the UK.

The company continues to consolidate a fragmented funerals industry, typically buying bigger-than-average and long-established funeral businesses funded from internally-generated cash. Its latest acquisition (16 Jun) is that of assets from Laurel Funerals, an operator of more than 80 locations, for £38 million in cash. Dignity only intends to acquire 36 sites in order to avoid any potential competition concerns, while the deal complements its geographic footprint and further enhances market share.

Underpinning already-resilient earnings are UK demographic trends, with the ONS predicting an end in sight for the declining death rate as the baby boomers generation ages. Dignity’s copious cash flow means it is able to hold relatively high debt levels and still lavish cash returns on shareholders. Last year, Dignity returned £64.4 million (£1.20 per share) to investors, its fourth capital return since its IPO in 2004 beyond normal dividends, following a debt restructuring involving the redemption and reissue of secured notes.

For the financial year to December 2015, Investec Securities forecasts improved pre-tax profit of £61.1 million (2014: £58.5 million) for earnings per share (EPS) of 97.1p (2014: 85.8p). Those estimates place Dignity on a prospective PE ratio of almost 22 times, a premium rating indicative of its defensive qualities and enviable cash flows. Next year, the broker looks for £66.8 million at the pre-tax line, translating into EPS of 106.4p. The comfortably-covered shareholder reward is forecast to rise from 19.5p to 21.4p in the current year, ahead of a hike to 23.6p in 2016. (JC)

Four low beta alternatives

Chesnara (CSN) 328p

Market Cap: £417.2 million

Prospective PE Dec 2015: 14.1

Prospective dividend yield: 5.8%

Beta: 0.38

Chesnara (CSN) is an unusual life insurer. For the most part it snaps up life insurance books closed to new customers. Historically it has focused on the UK and Sweden but it stepped out into a third territory in 2015 with the €67.8 million acquisition of the Dutch Waard Group. By managing the run down of these books efficiently it can generate significant cash because reserve requirements diminish over their remaining lives. In order to sustain its strategy the company has to buy new ‘closed books’ at a discount with its typical targets falling in a £50 million to £200 million range. There is also a profitable new business operation in Sweden.

CHESNARA KEY DEFENSIVE ATTRIBUTES

• Established track record

• Attractive dividend growth

• Low risk investing policy

• Strong cash generation

Costs are kept low with most back-office functions outsourced and so far the strategy has proved very reliable. The Preston-based firm has increased the dividend every year since the firm was established in 2004. Although on the surface dividends look insufficiently covered by earnings - based on 2015 consensus forecasts dividend cover stands at just 1.2 times - but the cash generative nature of the business should allay fears.

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In 2014 gross cash of £42.6 million exceeded the full-year payout by 89%. Its embedded value - a valuation metric for life insurance companies which shows the present value of future profits plus net asset value - has increased from £126 million in 2004 to £417 million in 2014.

In May Chesnara confirmed that it had successfully completed its transaction in the Netherlands which was funded by existing cash resources and a £35 million placing. Panmure Gordon analyst Barrie Cornes says: ‘We view the acquisition as providing Chesnara with a base from which it can consolidate other acquisitions in the country reinforced by the good working relationship established with the Dutch regulator.’

Essentially the company will look to repeat the same trick which has served it so well in the UK market with former chief executive Graham Kettleborough - who left after more than 10 years at the helm in December 2014 - noting when the deal was first proposed that the company might be halfway through the consolidation story in the UK but that in the Dutch market it had not really even started.

Stellar income credentials allied to its robust track record make Chesnara a useful port in a storm. Even better, a period of share price underperformance against the market and its sector, despite decent operational performance, makes now a good time to buy. (TS)

KCOM (KCOM) 93.5p

Market cap: £479 million

Prospective PE: 12.3

Dividend yield: 6.3%

Beta: 0.45

This has many defensive attributes. While share price upside is likely to be incremental rather than in surges, KCOM’s (KCOM) predictable nature makes it a fine low beta candidate that investors can tuck away for the long-run without sweating too much about operational cyclicality or the vagaries of stock market sentiment. According to our data from Sharescope, the stock’s beta stands at 0.45, so in other words, for each 1% move of the FTSE All Share, either up or down, KCOM shares typically gain or lose 0.45%.

Among the main operational reasons for its steady-eddie appeal is a decent track record for predictable performance. ‘KCOM’s strength is the consistency of delivery,’ says FinnCap analyst Andrew Darley, who flags the reliability of EBITDA (earnings before tax, interest, depreciation and amortisation), adjusted pre-tax profit and adjusted earnings per share (EPS).

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As a supplier of telecoms services to customers in Hull and East Yorkshire, plus network managed services nationwide, it has a core customer base on which it can rely. But interestingly, there are emerging opportunities for genuine top line growth for the first time in years, with possible acquisitions also on the agenda.

KCOM’s KEY DEFENSIVE ATTRIBUTES

• Consistent execution

• Strong cash generation

• High yield provides share price floor

‘Legacy revenue streams are declining, but the success of new contract wins, such as the HMRC contact centres, and the growth shown by Eclipse and Smart421 indicate the potential higher margin business to be won.’ This pair of businesses provide cloud-based managed service solutions to mid-sized clients, a hot space in which to operate as businesses demand faster, slicker and off-premises data hosting capabilities.

Darley flags impressively quick take-up of KCOM’s FTTP (fibre to the premise) strategy in its Hull and East Yorkshire heartlands. ‘Take-up rates of 33% of consumers are well in excess of national trends,’ the analyst points out, giving strong reassurance over the company’s roll-out plans to pass 100,000 homes by 2017. ‘Fibre take-up in the business sector is running at 50% of premises passed, aided by the SME access to the Government’s voucher scheme,’ he adds, referring to the Government’s superfast broadband incentive scheme worth £3,000 to businesses to achieve superfast broadband from a registered local service provider. The programme runs through to the end of February 2016, or until the nationwide £40 million budget is exhausted.

With typically strong cash generation, albeit a little off par last year due to fibre roll-out costs and HMRC’s typically slow payment, future dividends look well supported. The payout is a fundamental part of the investment story. KCOM promises to increase its payout by at least 10% for this year and next, implying a yield to March 2016 of 6.3%, substantially above the 3.2% sector average. (SFr)

Rank (RNK) 216.9p

Market cap: £835.6 million

Prospective PE: 15.5

Dividend yield: 2.6%

Beta: 0.66

Grosvenor Casino and Mecca Bingo owner Rank (RNK) is a UK-based company that isn’t affected by fears of a Greek exit or currency movements. There’s also an argument that when times are tough people are more likely to try their hand at winning money on Black Jack or enjoying a cheap night out at a bingo hall.

Rank has achieved an impressive turnaround since Henry Birch became its chief executive in May 2014, which means sentiment towards the stock is positive. The shares have risen by 31% over the past year and there is potential for further gains as the company continues to develop its digital offering.

RANK'S KEY DEFENSIVE ATTRIBUTES

• Unaffected by currency movements

• Growth delivered by internal improvements

• Relatively sheltered from economic downturn

Only a year ago Rank was reporting year-on-year pre-tax losses but it is now expected to deliver a profit of £71 million for the 12-month period ending June 2015. The company has improved its products, marketing and operational efficiency and has invested in its digital division, which has historically lagged its competitors. Although customer visits to its casino and bingo venues have fallen in line with the overall market, this was compensated by a 55% rise in digital revenue at Grosvenor and an 18% rise in digital revenue at Mecca in the third quarter.

Birch says the major parts of its digital development are still to come. The company is creating a ‘single wallet’ which will enable customers to use the same account at venues and online. He wants to develop a multi-channel offering which incentivises online customers to go to their local club and venue-based customers to play online when they get home.

Birch claims Mecca Bingo is already one of the top three online bingo operators. ‘We’ve got that brand heritage and recognition and a large customer base and, frankly, no one knows bingo like we do,’ he says.

The company is looking out for potential acquisition opportunities to further grow its digital business or help derive synergies from its retail business. It is also launching a new bingo brand and hopes to break ground on its first club at the end of this year. Birch says Rank will spend significantly below £1 million on the new club.

Rank’s net debt was £137 million at 30 June 2014 but it is highly cash-generative and the figure is expected to reduce to £75 million for the financial year that’s just ended. Birch says it may also return some cash to shareholders. (EP)

S&U (SUS) £22.20

Market cap: £264 million

Prospective PE: 15.2

Dividend yield: 3.0%

Beta: 0.08

Consumer lender S&U (SUS) is the lowest beta stock on our list. Looking for low beta stocks can be a good way of identifying defensive or unusual businesses. Home credit and auto lender S&U fits the bill for a number of reasons, though we think investors should take its beta reading with a pinch of salt.

Morningstar data shows S&U has a three-year beta as low as 0.04 but such a reading is primarily driven by a low correlation to the general market rather than low volatility.

These calculations must always be taken with a grain of salt at smaller companies, according to analyst Keith Baird at house broker Panmure Gordon. ‘Small cap stocks like S&U tend to fall asleep for long periods and then wake up around results or news announcements,’ Baird says. ‘For that reason beta measurements are not always as precise.’

S&U’S KEY DEFENSIVE ATTRIBUTES

• Sensible approach to leverage

• High returns on capital

• Track record of lending quality

Baird points to sector peer Provident (PFG), a much larger and more liquid stock operating in similar markets to S&U, which has a beta of 0.87. S&U’s ‘true beta’ is likely to be closer to this number.

Investors considering low beta stocks can ask a couple of simple questions to determine whether the numbers make sense. First, does S&U operate in a market we’d expect to be uncorrelated to the broader economy?

The answer, for us, is no. Financial companies, particularly those lending to consumers, tend to be closely tied to economic fortunes.

Sectors which are usually more insulated from changes in GDP include utilities because of the stable and regulated nature of their products, insurance companies for similar reasons and consumer staples.

Second, does S&U have a business model able to weather a tough economy? On this point, we’d say yes. Earnings at the business declined little in 2007-2009, one of the worst financial crises in a century, and grew even more rapidly after recession subsided. That indicates S&U possesses a resilient business model and a good management team.

Third, even the most unusual and high quality business models can become more correlated to markets when they deploy excessive leverage. S&U generates high returns on tangible capital with a cautious approach to leverage, meaning financial risk is less of a factor here. (WC)