1/11/08

Defensive Stocks -- Are They Really?

Chances are, you've probably been hearing a lot about defensive stocks lately. I have been wondering about them myself, and decided to investigate how they have fared recently and in the last bear market.

To this end, I chose to look at a (perhaps) random sampling of stocks that fall within the "defensive" category. These stocks, most of which you probably heard of are:

Altria (MO) -- tobacco products

Anheuser Busch (BUD) -- Alcoholic beverage producer

Coca Cola (KO) -- beverage producer.

Consolidated Edison (ED) -- A utility company serving New York, and parts of New Jersey and Pennsylvania

Diageo (DEO) -- alcoholic beverage producer

General Mills (GIS) -- packaged consumer foods producer

Johnson & Johnson (JNJ) -- all sorts of products in beauty, health, and household areas.

Kellog (K) -- packaged consumer foods producer

Kraft (KFT) -- packaged consumer foods producer

Pepsico (PEP) -- beverage producer

Proctor & Gamble (PG) -- all sorts of consumer products in beauty, health, and household areas.

Reynold's American (RAI) -- tobacco products producer

All but one of these are in the consumer staples sector--what people buy on a regular basis whether because it's needed like food and soap, it's socially mandated like deodorant and shaving cream, or it's addictive/stress relieving like alcohol and tobacco. Con Ed, in the utility sector, is similar in that having electricity has become a basic life necessity. What all these companies have in common is their large size, dominance in their respective industries, a long history of steady dividend increases, and daily demand for their products that should not disappear because of an economic downturn. They are big, boring stocks that almost everyone has heard of.

I looked for the starting and ending dates of the last bear market, but could not find any firm dates. I've decided to take a different approach: look at the S&P 500 index to find its peak and low, and see how the defensive stocks listed above did during that period. I chose the S&P 500 because I could not find a decent chart for either the MSCI US Broad Market Index or the Wilshire 5000, which aim to track the entire US stock market.

The last major drop of the S&P started in September 2000 and ended in October 2002. As you can see from the chart, it declined roughly 47% over the two year period.

Over the same period, as you can see from this chart, only Coca Cola (KO) finished negative, around 10% down. Had you actually held the stock during this time, your loss would be about 2% less, given that you would have collected 8 dividend payments, amounting to $1.08 a share. While a losing stock, Coca Cola solidly beat the S&P.

The other stocks mentioned above, as you can see from the chart, had positive returns, the great majority of which were between 20 and 40%. That's excellent in a market when the S&P loses almost half its value. And this doesn't count dividends. All these companies offered generous yields and steady dividend increases.

The market had two peaks recently, before heading downward. The first happened in mid July, 2007, then an all time high, and the second happened in October, 2007, the all time high. You can see the chart here.

For the first downward period, as you can see from this chart, all but one of our defensive stocks beat the S&P. However, only four ended the period in positive territory. Not a good result, but certainly better than the broader market.

For the second downward period, from October, 2007 to present, all of our defensive stocks beat the S&P, and the majority were in positive territory. Of course, no one knows what will happen next and how these stocks will do if the broader market continues its decline.

This is all inconclusive, but I would venture to say that buying defensive stocks at market peaks is safer than buying a broad market index like the S&P. Better yet, buying defensive stocks and holding them over the long term seems to be a good strategy. Holding the above listed stocks since the first peak I talked about (September 2000) until now would have given you fantastic market beating returns, with the majority of the stocks listed above returning between 20 and 60%, three of them doubling, and one returning around 240%, all excluding steadily rising dividends. Only Kraft finished flat, excluding dividends. Any of these stocks would have been a better investment than the S&P, or incidentally, keeping the money in the bank (return wise, not risk wise).

To answer the question posed in the title of this post, I would say yes (caveat: from 9/00 to 1/08), defensive stocks are safer than others.

If you're interested in consumer staples, you might want to investigate the following ETFs: KXI, XLP, VDC. Be sure to examine their holdings, as some might not truly be consumer staples. This is debatable, but I don't consider Walmart to be in the consumer staples category.

If you're interested in utility companies, you might want to investigate these ETFs: XLU, IDU, VPU. Because of their defensive nature, these have been bid up recently.

If disclosure is necessary: I own RAI. My girlfriend owns MO and VPU.