Defensive stocks

When volatility strikes Wall Street, many investors seem concerned about their portfolios. Although, as a dyed-in-the-wool value investor, I view these events opportunities to pick up more shares of my favorite companies at bargain prices, it’s understandable for those who aren’t professional investors, or who take a different approach to acquiring securities, to get nervous.

After the correction, a friend of mine asked me what kind of portfolio I would construct for someone who wanted to own equities (stocks) but was keen on enjoying some insulation from price gyrations.

As we had a conversation over coffee, I started thinking that the information might be useful to some of my readers. Here's an overview of some of the things that would fit the bill.

Stocks With Dividend Yields Greater Than Long-Term Treasury Yields Are a Good Buffer Against Downturns for Defensive Investors

The first, and perhaps most powerful, defense is a stock that has healthy earnings and a relatively good dividend payout ratio and dividend yield, especially when compared to the yield that is available on the risk-free United States Treasury bond. The logic is actually pretty simple: Investors are always comparing everything to this so-called “risk-free" rate. The reason? When you buy a debt obligation of the United States, you can be certain that you are going to get paid. As the wealthiest nation in the world, all the government has to do is raise taxes or sell off assets to pay its debt.

When the dividend yield of a stock is the same as the Treasury bond, many investors would prefer to own the former. Not only do you get more cash from the dividend yield because of favorable tax treatment (dividends are subject to a maximum 23.6% Federal tax rate while Treasury bonds, although exempt from state and local taxes, can run as high as the 39.6% tax bracket) but, perhaps more importantly, you get the capital gains generated from an increasing stock price.

After all, what reasonable person wouldn’t want to have their cake and eat it too?

Here’s how it protects you during a down market: As the stock price falls, the dividend yield goes up because the cash dividend is a larger percentage of the purchase price of each share. For example, a $100 stock with a $2 dividend would have a 2% dividend yield; if the stock fell to $50 per share, however, the dividend yield would be 4% ($2 divided by $50 = 4%.) In the midst of a market crash, at some point the dividend yield becomes so high that investors with excess liquidity often sweep into the market, buying up the shares and driving up the price. That’s why you typically see less damage to high dividend paying stocks during down markets. Combined with the research done by Jeremy Siegel, this is yet another reason investors may want to consider these cash generators for their personal portfolio.

To learn more about this topic, read Why Dividend Paying Stocks Tend to Fall Less During Bear Markets and 3 Reasons Dividend Stocks Tend to Outperform Non-Dividend Stocks.

Consumer Staple Companies and Other Blue Chip Stocks With Conservative Balance Sheets and Durable Competitive Advantages Are Among the Best Types of Defensive Investments

True investors are interested in one thing and one thing only: Buying companies with the highest net present value earnings at the most attractive price possible.

In strained economic times, the stability of profits is extremely important. Often, the most successful stocks are those that have durable competitive advantages. These consumer staples sell things such as mouthwash, toilet paper, toothpaste, laundry soap, breakfast cereal, and soda. No matter how bad the economy gets, it’s doubtful that anyone is going to stop brushing their teeth or washing their clothes.

Finding these companies isn’t hard. They are often known as blue chip stocks and make up the Dow Jones Industrial Average. They include household names such as 3M, Altria, American Express, Coca-Cola, Exxon Mobile, General Electric, Home Depot, Johnson & Johnson, McDonald’s, Procter & Gamble, and Wal-Mart. They often have extremely large market capitalizations.

Good Companies With Large Share Repurchase Programs Often Make for Good Defensive Holdings

Some companies, such as AutoZone and Coca-Cola, regularly repurchase enormous amounts of their own shares.

In a falling market, this can help reduce pressure because as the stock is sold, the company itself is often standing by with its checkbook open. There is a double benefit here in that if the stock does become undervalued, long-term shareholders benefits from these repurchases as the enterprise is able to reduce the total shares outstanding far more quickly as a result of a lower stock price, increasing future earnings per share and cash dividends for the remaining stock. This is especially beneficial when things turn around the stock recovers because the shares that remain get a higher boost.

Stocks Trading at Reasonable Valuations as Measured by Historical Metrics Make for Good Potential Defensive Selections

Of course, if you only buy a diversified basket of stocks that traditionally have characteristics associated with value investing such as low price to earnings ratios, low price to book ratios, low price to sales ratios, diversified operations, conservative balance sheets, etc., the odds are good that you will emerge from the wreckage unscathed over the long-term. This is why value based money management shops such as Tweedy Browne & Company have managed to return such impressive results to their fund holders and private investors over the decades. For most investors who lack experience, this is best achieved through a low-cost index fund.

A Few Other Thoughts

If you don’t have the ability to analyze financial statements and calculate a conservative estimate of intrinsic value for the assets in your portfolio, it is a wise policy to maintain widespread diversification.

Consider keeping a portion of your portfolio in international investments by investing in a highly rated, low risk global mutual fund or index fund.

Never invest any capital into equities that you might need within the next five years.

If you can’t handle price volatility, consider reducing the overall gyrations of your portfolio by including a substantial bond or fixed income component. Although this might lower your returns over subsequent decades, if it reduces the chances of you selling everything in a panic, it can provide a workable compromise.