If there's anything the past few years have taught investors, it's to be ready for anything. The stock market is currently on the rise – especially now that it seems the Federal Reserve is nearing the end of its rate hike cycle – but investors should still consider defensive stocks as part of a well-rounded portfolio. But what are defensive stocks and how do you find the best ones?
Defensive stocks have long been a popular addition to portfolios. In his groundbreaking book on value investing, The Intelligent Investor, Benjamin Graham discussed their characteristics. Graham argued that defensive stocks should be moderately priced, have a good record of paying dividends and be conservatively financed.
In short, defensive stocks can protect investors from the vicissitudes of the stock market thanks to these traits that can produce stable returns, good income and long-term value for the investor.
What are defensive stocks in the stock market?
The typical defensive stock will have three major features:
- a good history of growing dividend payments
- a conservatively financed balance sheet with little debt
- an inexpensive valuation
Dividends. Companies that have a long history of dividend payments and have grown them over time tend to have stable price histories.
For example, the best dividend stocks tend to fall less in bear markets. This works if the market believes the company will maintain the dividend, even while other stocks are tumbling.
Moreover, let's say that a stock has a stable history of dividend payments over an extended period of time. Also, let's assume the stock presently has an attractive dividend yield of 3.5%.
Therefore, if its dividend payment rises by 5%, the market will tend to push the stock price higher by 5%, so as to maintain the same 3.5% dividend yield.
In addition, there is a more fundamental point about dividend-paying stocks that makes them defensive investments.
Companies normally can only pay dividends over a long period if they have positive earnings or strong free cash flow (FCF), which is the money left over after expenses, interest on debt, taxes and long-term investments that are needed to grow the business have been paid. In other words, they are fundamentally healthy.
Lastly, the best defensive stocks typically have low payout ratios. This means that no more than 50% to 60% of the company's earnings are paid as dividends. This allows the company to reinvest its retained earnings for future growth.
Balance sheet. Another major trait of a defensive stock is a conservative balance sheet. This means investors should stay away from certain types of stocks with the highest dividend yields. This is because their share price is spiraling, making their yield rise, and/or because they may have taken on large amounts of debt in order to pay out their dividends.
Another pitfall is to avoid companies that have issued too many shares. For example, some high-yield real estate investment trusts (REITs) can only afford their lofty dividends by constantly issuing new shares. So, despite the high yield, the stock will not tend to do well over time.
Valuation. Lastly, a major characteristic of defensive stocks is a cheap valuation. It has been shown in academic studies that over long periods, low price-to-earnings (P/E) and low price-to-book value (P/B) stocks do well over time.
What are drawbacks to buying defensive stocks?
One drawback with defensive stocks is that they tend to have conservative returns. This means they typically won't rise as much as during bull markets.
Of course, the opposite side is also true – they tend to not fall as much in bear markets.
Another drawback is that defensive stocks tend to be either in cyclical industries or low-growth arenas that aren't popular. For example, the company might be profitable, but its earnings or sales growth rate could also be low.
And that is the conundrum for investors. The stock is cheap due to its defensive traits. But its inexpensive valuation is due to its slow growth rate, despite its stable dividends and conservative balance sheet.
What are examples of defensive stocks?
Here are a few examples of defensive stocks in today's market.
Old Republic International (ORI): This is a large multi-line insurance company that has a 42-year history of annual dividend growth. Moreover, its dividends don't represent more than 40% of earnings. Meanwhile, ORI stock has an inexpensive valuation of 10.3 times earnings, boasts a 3.7% dividend yield and has a conservatively financed balance sheet.
Chevron Corporation (CVX): Chevron is a very large oil and gas company that ended fiscal 2022 with over $235 billion in revenue and $37 billion in free cash flow. That FCF allows the company to pay an ample dividend, which has grown every year for the past 35 years. So, as it stands, the blue chip stock now has an attractive 3.8% dividend yield. Its valuation is also cheap at less than 10.2 times forward earnings. Meanwhile, Chevron finances its operations very conservatively, with just 14% net debt compared to its shareholders' equity.
HP (HPQ). HP is a profitable imaging and printing products company with related technology solutions and services. HPQ is a defensive stock for several reasons. First, the company has paid a dividend for 33 years, and raised it in each of the past 12. Second, its valuation is attractive, with the tech stock trading at just 8.9 times forward earnings. Lastly, HPQ is considered a defensive stock as its balance sheet is reasonably financed. For example, it has produced $2.3 billion of free cash flow on a trailing 12-months' basis. This can be used to cover its dividends and pay down the $8.8 billion of net debt on its balance sheet.
