Defensive stocks may be winners in a slow upturn

LONDON (Reuters) - Classic defensives such as food and drug shares tend to do better than cyclicals in an economic downturn, but they could also outperform the market on the way up as many analysts say a recovery is set to be slow.

These defensives often underperform once the green shoots of recovery are anticipated, and true to form these stocks have been left behind in the post-March stock market rally, but many offer what has been termed "defensive growth".

"A weak recovery plays well for defensives, we should be happy to be overweight in defensive stocks," said equity strategist Ewen Stewart at Investec Securities.

He said that with a lacklustre recovery seen at best, investors would do well to stay cautious and be prepared to pay a premium for the certainty that comes from big defensives with their staple products and rising exposure to emerging markets.

"Recovery, should it come, is likely to be a mild one. This could also play into the hands of those sectors which offer investors a combination of cheap valuations and reasonable growth prospects whatever the weather," said Citi's strategist Adrian Cattley.

He pointed out that the four big defensive sectors -- food and beverage, healthcare, telecoms and utilities can gain in rising equity markets -- but it is the first two he finds most interesting as they outperformed rising markets in the 1980s.

"We suspect that consumer defensive companies in food, beverages, tobacco, HPC and perhaps healthcare are more likely to fit the bill rather than telecoms and utilities," he said.

In this area, Citi analysts have picked food groups Nestle (NESN.VX) and Unilever Plc/NV (ULVR.L) (UNc.AS), cigarette maker BAT (BATS.L), home and personal care (HPC) group Reckitt Benckiser (RB.L) with drug groups GlaxoSmithKline Plc (GSK.L) and Sanofi-Aventis (SASY.PA) among its top ten defensive picks.

These companies still face challenges, with food groups seeing limited ability to raise prices in a downturn, while drug companies face lower returns on research and development, key patent expiries and U.S. government healthcare reforms.

POSITIVE FACTORS

But analysts say big food groups such as Nestle, Unilever and Cadbury (CBRY.L) should benefit from falling commodity prices, such as milk for Nestle and vegetable oil for Unilever, and their big exposure to growing emerging markets.

Lower costs of commodities such as barley will also benefit brewers such as SABMiller (SAB.L), while a recovery would benefit high-debt groups such as brewer Anheuser-Busch InBev (ABI.BR) and wines and spirits group Pernod Ricard (PERP.PA).

Healthcare groups such as GlaxoSmithKline and Sanofi-Aventis could gain from further restructuring, their growing emerging market exposure and diversification into growth areas such as vaccines and consumer health, they added.

But not all defensives are likely to outperform as Citi analysts believe telecoms will be challenged by price deflation, and utilities from stretched balance sheets.

Investec food and drinks analyst Martin Deboo said he picked stocks within his sector that had some control over their destiny, such as Unilever with its scope for restructuring and Tate & Lyle (TATE.L) with its new incoming chief executive.

Within the drinks sector, he picked out spirits giant Diageo (DGE.L) because most of its products, such as Smirnoff vodka and Johnnie Walker Red whisky, are at a mid-market pricing level rather than luxury prices.

Deboo said food and drinks stocks offer good value due to their stable earnings flow, despite trading at a 20 percent premium to the UK market.

Currently, the DJ European Food and Drink index .SX3P trades on 13.7 times 2009 forecast earnings compared to the FTSE 100 index .FTSE on 11.6 times.

In the second quarter, the FTSE 100 .FTSE outperformed the Food and Drink index by around 3 percent. While the FTSE 100 rose 8.2 percent in that period some defensives such as GSK slipped 1.7 percent.

So after being the among the biggest losers in the rising stock markets of the second quarter, defensives may be worth a second look, as Citi analysts point out the four big defensive sectors have outperformed the UK market since the early 1980s.

The FTSE 100 index rose more than 30 percent between early March and early May but has since slipped 9 percent from its May peak as a global equities recovery slowed.

(Reporting by David Jones; Editing by Sitaraman Shankar)