Defensive Diversification Is Not Such a Bad Thing

The Toronto Stock Exchange (TSX) has continued to climb, and many of even the most high-profile bearish fund managers such as Prem Watsa of Fairfax Financial Holdings Ltd. (TSX:FFH) have reduced (or in Mr. Watsa’s case eliminated) downside hedges to maximize the potential upside from a continued bull market rally.

Numerous investors with far less experience than the head of one of Canada’s preeminent large funds can see that reducing downside hedges at a time when valuations have peaked and the financial markets are beginning to look over-inflated is risky business indeed. The Canadian housing market is now showing signs of cooling off, and economic worries about pervasively low oil prices as well as potential trade disputes with Canada’s largest trading partner are driving a “short Canada” campaign by a number of well-known short-sellers.

Defensive hedges are companies that tend to hold their value much better in a financial downturn than cyclical stocks (which, by virtue of their name, have down cycles). Many iconic defensive stocks have seen their valuations increase, interestingly, over the past few months as investors consider ways of hedging downside exposure while still retaining the upside of these defensive names in a bull market that may still have legs.

Trying to time when a correction, or God forbid a recession, hits the Canadian market can be near-impossible; what is possible, however, is preparing for such a situation by diversifying a portfolio with a stable of defensive names.