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Stocks & Markets

Stocks: Finding Havens Amid Rising Volatility

As major U.S. stock indexes tumble from their April highs, not all stocks are being hit equally. While the broad Standard & Poor's 500 index is down 5.6 percent so far in May, many so-called defensive stocks have held steady.

The S&P 500 Consumer Staples index is down just 0.68 percent in May, the best performer of 10 major sectors in the S&P 500. On May 17, shares of consumer staples company Kellogg (K) hit a new 52-week high, trading at their highest price since October 2008.

Investors may be dashing toward safe havens because of recent headlines, like the fiscal crisis in Greece. Or they may be just taking profits after the 80 percent run in the S&P 500 from Mar. 9, 2009, to Apr. 23, 2010. "The market was due for a correction, and Europe was just the excuse," says Mitch Schlesinger, chief investment officer at FBB Capital Partners.

In any case, after the past year's rebound, the economy and stock market may be moving into a new phase, says Jim Meyer, principal and chief investment officer at Tower Bridge Advisors.

In the first phase, "old problems start to fade away," he says. Earnings rebound and stocks bounce back. In the second phase, "the healing process" continues but new problems start to surface—problems like the fiscal woes in Greece and worries about other nations' debt loads, or the prospect of higher inflation or higher interest rates.

Stock Refuges

An increase in volatility in the stock market shows investors are concerned. The Chicago Board Options Exchange Volatility Index, or VIX, is up 82 percent in the past month. For investors, defensive stocks—often steady, almost boring in their price action—are one way to avoid that kind of stomach-churning stress.

But where to find these refuges among equities?

A traditional defensive sector is utilities, but not everyone is a fan. There is a "question mark" over the sector because of worries about regulation and high raw material costs, says Oliver Pursche, co-portfolio manager of the GMG Defensive Beta Fund (MPDAX). In May, the S&P 500 Utilities index is down 2.7 percent, the third-best performer after consumer staples and telecom.

Pursche prefers consumer staples stocks like PepsiCo (PEP) and CVS Caremark (CVS), both of which he owns.

Consumer staples companies tend to have more stable business models because they sell products people need to buy—a contrast to the more elective products offered by the consumer discretionary sector.

If you're concerned about your job, "you're going to put off buying a new couch or bedroom set," Pursche says. "You're not going to put off buying shampoo or Band-Aids."

Growth Traits

At the depths of the recession in the first quarter of 2009, sales at S&P 500 consumer discretionary companies fell an average of 13.5 percent. Consumer staples sales dropped 5.5 percent.

While sales are relatively stable at home, many leading U.S. consumer staples companies also offer growth abroad. Meyer, who owns Kellogg and Colgate-Palmolive (CL), says both companies are doing a good job "penetrating emerging markets." PepsiCo, meanwhile, has "done a better job of understanding the Chinese marketplace than anyone else," Pursche says.

Strong companies with solid business models can be found in almost any sector. FBB Capital's Schlesinger points to International Business Machines (IBM), which he owns. Though IBM's sales slipped 7.6 percent in 2009, profits still rose, with net income up 8.9 percent last year despite the recession.

As companies spend to modernize their computer systems, "technology can be defensive because it's one of the few areas that is receiving capital investment," Schlesinger says.

Hennessy Funds portfolio manager Frank Ingarra Jr. offers three criteria for good defensive stocks: strong cash flow, strong dividends, and size. The bigger a company, the more diversified its revenue streams. "A larger company should be better-protected in down markets," Ingarra says.

Cheap Finds

Dividends are valuable at a time when so many other investments—from money-market funds to bonds—pay tiny yields. "You're better off buying a stable equity name and getting paid in the dividend," says Thomas Nyheim, portfolio manager at Christiana Bank & Trust.

Meyer points out that Johnson & Johnson's (JNJ) indicated dividend yield of 3.43 percent exceeds the 3.36 percent yield on the 10-year U.S. Treasury note.

Portfolio managers say there is one more reason defensive stocks may return to popularity: They're cheap.

During the past year's rally, many large-cap companies with defensive characteristics fell behind the rest of the stock market even as their profits bounced back. As a result, the stocks look inexpensive on gauges like price-earnings ratio. "Multiples on [defensive stocks] have contracted pretty dramatically," Nyheim says.

He cites Johnson & Johnson as an example: Over the last 20 years, the company has had an average p-e ratio of 22, according to Bloomberg data. The stock's current p-e multiple is 13.5.

A defensive stock portfolio can help investors avoid volatility and rest easier at night. But investing pros do warn that getting too defensive can have its costs, too, as you can miss out on gains in riskier stocks.

"It's important for investors not to overdo it," Pursche says. Despite scary headlines, "we continue to see economies around the world improving."

Still, you never know what economic threat might be around the corner. "It's always a good time to be a little bit defensive," Schlesinger says. It's a good idea "not to keep your foot on the accelerator all the time."

Steverman is a reporter for Bloomberg News in New York.

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