Defensive Stocks are Important Too

Records are made to be broken, but this is just ridiculous.

The latest moon shot is Groupon, Inc., the Chicago-based deal slinger that Forbes recently tagged as the fastest growing company ever. I guess $500 million in revenue in your second year has that effect on people. It makes you sexy.

It didn’t take long for Google, Inc.’s (GOOG) carnivorous instinct to pick up the scent.

The cash-heavy juggernaut swung through town in mid December to dangle a $6 billion offer in Groupon’s face. This is an immediate “I never have to work again” moment. But just when it looked like they were about to go all the way, Groupon cheered rebel forces around the world and walked away.

Ideology was definitely in play. Groupon wants to hang on to its identity and call its own shots.

But it also comes down to numbers.

As in, Groupon thinks it’s worth more than $8.2 million a day in its first two years.

It’s a conviction play that says a lot about the market right now. Companies are feeling confident and want to roll the dice on bigger gains down the road.

In the world of stocks that’s called beta. High beta means more risk but also more upside.

Just like Groupon, high-beta stocks are the ones that get all the glory, kind of like the star running back or basketball player. But for every guy scoring points, you need at least a few playing defense, which is why the best teams have both.

Playing Defense is Important Too

The same is true for your portfolio. Defensive stocks provide your portfolio with stability. You probably won’t see huge gains in an up year, but that also buys you more protection in a down year.

Here are two important things to look for in a good defensive name.

Stable Business-You want to find a company with a very stable and predictable business. Think along the lines of things people can’t live without, from soap and toothpaste all the way up to food and energy. These less discretionary goods provide the company with protection against a weak consumer environment or economic uncertainty.

Dividend-Dividends are probably the most underrated financial tool in the market, responsible for 44% of the S&P500’s total return over the last 80 years. That dividend yield compounded over many years has a powerful effect and provides additional protection against short-term volatility.

Here’s another thing to consider. Dividend stocks tend to be popular when the overall market is weak as investors rotate into more conservative segments of the market. Increased investor demand supports capital gains in a flight to safety.

So now that we have painted a picture of a good defensive stock, let’s go ahead and take a look at our top three picks in the category.

McDonald’s Corp. (MCD)

Even though McDonalds (MCD) has been in business before Ronald McDonald knew how to ride a bike, this is actually kind of a turnaround story.

By the mid 2000’s the golden arches had lost their luster. McDonald’s share price was in the toilet and revenue had been slumping for years. So with a long line of disgruntled shareholders behind it, the Board of Directors decided to bring in a new CEO and clean house.

That resulted in the company’s “Plan to Win” strategy from 2005, where franchisees were asked to clean up their restaurants, operations were restructured to increase productivity and new products were launched to boost sales.

The results have been impressive. Since 2005, sales, margins and earnings have all been on the upswing.

McDonald’s has successfully revitalized its brand and is enjoying the fruit of its very loyal customers and global footprint.

As it stands, McDonald’s has more than 33,000 stores in 117 countries and a market cap of $78 billion, which makes this a very big company. But it hasn’t allowed its size to slow it down. In 2007 when the economy began to weaken, McDonald’s took a very defensive stance and redesigned its $1 menu to cater to value-driven consumers. The strategy worked, supporting sales in a weak market.

McDonald’s has also been on the offensive, grabbing market share from cross-industry competitor Starbucks Corp. (SBUX) with its new value driven McCafe. It’s another example of how this big boy has learned to stay nimble in a competitive environment.

Even though MCD has seen some solid gains over the last few years, shares still have value, trading with a forward PE of 15X, below its 5-year average from 2004 to 2008 of 16X.

Throw in a reliable 3.3% dividend yield and those golden arches are starting to look pretty shiny.

CPFL Energia SA (CPL)

For our next pick we’re going international, CPFL Energia SA (CPL), an electric utility out of Brazil with a market cap of $12 billion and dividend yield of 7.3%. In case anyone didn’t notice, that’s an awesome yield, particularly in the weak interest rate environment.

This definitely qualifies under the stable business category. Electricity is something that most consumers can’t live without, even the most frugal. Selling electricity is also a regulated activity, which keeps competitors at bay.

We saw that stability play out in 2008 and 2009. CPL’s share price was down sharply from its high, just like most of the market. But its revenue and earnings we’re only down a fraction of that. So when investors realized the world wasn’t coming to an end and started buying stocks again, CPL was a top choice because it had become so undervalued.

In addition to the stable business and nice dividend, we also have some upside. Brazil’s emerging market economy is enriching its citizens and fueling demand for middle-class amenities. That kind of long-term, secular trend bodes well for companies providing those services.

But in spite of the strong profile, CPL still has value, trading in line with its peers with a forward P/E of 14.5X.

Buckeye Partners LP (BPL)

That brings us to our last pick, Buckeye Partners LP (BPL), an energy-services company with a market cap of $3.5 billion. This helps us cross the spectrum of market caps with a mid cap, large cap and mega cap on our list of defensive stocks. It also means we have one purely domestic stock, one purely international and one that is extremely global.

BPL is a fairly specialized company, owning and operating a 5,400 mile network of pipelines that deliver refined petroleum products like gasoline and jet fuel to airports. It also offers terminaling and storage services, adding a touch of diversity to its business mix. As an energy-services company, BPL is much more insulated from fluctuations in crude and natural gas prices that create volatility for companies working in production.

This is another play on our strategy to target businesses with steady demand, with consumer and commercial travel usually holding up even during times of economic weakness. But much like MCD, BPL isn’t kicking back and resting on its laurels.

The company has been fairly active over the last year, completing a number of acquisitions to diversify its asset base and drive earnings. That has weighed on the company’s balance sheet a bit, but its debt-to-equity ratio of 123% is only marginally higher than its peer average of 105%.

Getting into our valuation conversation, BPL is trading with a forward P/E 19X, directly in line with its peer group.

The overhead view on our defensive stocks looks pretty solid. We have a global food giant, an international electric utility and a domestic energy services company. These companies are all working in areas that benefit from stable demand and very high barriers to entrance, something that will help buoy the portfolio during volatility and provide solid upside in a good market.

And 2 More for Fun

Here are two more stocks that fit the profile that are worth taking a look at.

Exxon Mobil Corp. (XOM) is the world’s largest energy company, with operations all over the world and a market cap of $380 billion. As an integrated energy company, Exxon operates across the entire distribution channel, which protects it from weakness in one particular segment of the market. It also produces an unbelievable amount of free cash flow, which is uses to buy shares back, pay its dividend and invest in future growth. And with a dividend yield of 2.3%, it has the income side of the equation covered too.

Verizon Communications, Inc. (VZ) is an interesting pick right now because the company finally landed a deal to provide service for Apple, Inc.’s (AAPL) extremely popular iPhone. Analysts estimate that could mean an extra 9-13 million subscribers in its first year as iPhoner’s are freed of their obligation to ATT&T, Inc. (ATT). Verizon is a big company though, with a market cap of $100 billion, so it probably won’t produce the long-term gains of a small cap. But with a hefty dividend yield of 5.4% and a flashy new contract with Apple, VZ could see a nice boost in sales and earnings over the next few years.

That’s it for now, but we’ll be looking at some more stocks next week as we begin to explore our favorite sectors, so be sure to check in.

In the meantime, here is a follow up to the Groupon story. It looks like the company is in early talks with Goldman for an IPO.

Goldman CEO Visits Groupon to Pitch IPO

And here is one more that talks about how Warren Buffet became a successful investor. Note that dividends and diversification are both on the list. Definitely worth taking a quick look.

3 Qualities Behind Warren Buffets Success

Your Investment Partner,

Mike

ABOUT THE AUTHOR

Michael Vodicka

Michael Vodicka is the president and founder of the Vodicka Group Inc., a licensed investment advisor (Series 65) and a financial journalist.