When the market starts getting crazy, I resist the urge to put my portfolio into retreat mode and load up on so-called "defensive" stocks. The reason is that I like to focus my investing on the best opportunities available, and when everyone is rushing to get defensive, the potential returns from defensive stocks get pushed down.
That said, there are some very valid reasons for buying defensive stocks, even if they aren't the cheapest. One primary reason is that they tend to have much lower volatility than the rest of the market. If that lower volatility can help an investor avoid panicking during market craziness, that can often be a big win.
Generally speaking, defensive stocks also tend to be high-quality, stable businesses that pay dividends. There's nothing wrong with buying great businesses -- in fact, focusing on great businesses is a key for Warren Buffett. As for dividends, they're getting a lot more attention again recently after being largely ignored for a long time, and that's a great thing because dividends can seriously juice your returns.
Rules for defense
If you're looking to play a little defense in your portfolio, you better make sure you're grabbing stocks that are actually defensive. Here are three ways to try to make sure of that:
Skip the cyclicals. When the economy hits a down cycle, some industries and companies suffer more than others. If defense is your game, financials like Citigroup (NYS: C) , materials companies like ArcelorMittal, and industrials like Caterpillar (NYS: CAT) are not your best bets. Instead, stick with industries like health care, consumer staples, and utilities
Watch the debt. Cyclical or not, few companies are able to skate along when the economy is struggling. For that reason, a heavy debt load can cause big problems during a downturn even if the company isn't a cyclical.
- Mind the beta. Normally I don't have much use for beta. However, as a measure of the extent to which a stock moves in relation to the rest of the market, looking for low betas can help you find stocks that won't be as volatile as the rest of the market.
Three for a stronger "D"
With those three rules in mind, here are three stocks that investors should consider to bolster their portfolio's defense.
- Johnson & Johnson (NYS: JNJ) . If we look at the big pharmaceutical companies, we can easily find cheaper options than J&J. Pfizer (NYS: PFE) , for instance, trades at 8.5 times expected forward earnings, while Merck (NYS: MRK) has a P/E of 8.4. So why go with the more expensive J&J? Because we're playing defense here and J&J has broader, more diversified business with less risk from expiring drug patents. Its valuation multiple might not be the lowest, but with a 3.6% dividend, a five-year beta of 0.6, and a debt-to-equity ratio of 30%, it's a stock you can feel very comfortable with even when the market is quaking.
- Procter & Gamble (NYS: PG) . Gillette, Crest, Tide, Pepto-Bismol -- these are just a few of the many blockbuster brands at P&G. When tough times strike, consumers may not be able to go on exotic vacations or buy the biggest big-screen TV, but I'll bet you that they're still shaving, brushing their teeth, doing laundry, and (maybe even more so) treating upset stomachs. With a 3.4% dividend, a debt-to-equity ratio of 47%, and a five-year beta of 0.5, rarely will P&G's stock inspire panic.
- Consolidated Edison (NYS: ED) . With the health care and consumer staples industries covered, we'll round out our three with a utility. Con Edison's primary business is providing electricity and gas to millions of customers in New York City and Westchester County. That is, in good times or bad, if the folks in New York want to keep their lights on, they're going to keep paying Con Ed. Con Ed's stock has a five-year beta of 0.3 -- which makes the two stocks above look positively wild -- a relatively high, but still reasonable, debt-to-equity ratio of 93%, and a very sweet 4.3% dividend.
You didn't think you'd get out of this without a catch, did you? Defensive stocks can help you weather tough, volatile times in the market and let you get some more restful sleep. However, the danger is for investors that cuddle up to defensive stocks after the market starts getting nasty and then, when the market soars during a recovery, get frustrated that the defensive picks don't keep up, jettison their defense, and buy the highfliers after they've had their big gains.
You know what the result of that is? It's heartbreak. Every time. Without fail.
If you buy defensive stocks because you think the market is about to go down, all you're doing is timing the market, and without a functioning crystal ball, you'll probably be disappointed with the results. If, however, you add defensive stocks as a steady part of your portfolio that may not soar during the good times, but also won't make you cry "Uncle!" during the bad, you may just find yourself with some more zen in your portfolio.
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At the time this article was published Fool contributor Matt Koppenheffer owns shares of Johnson & Johnson, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.
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