Tuesday, January 11, 2005


I have recently often used the term "defensive stocks". This morning a reader asked what the term means or what stocks are considered defensive.

Dictionary definitions of defensive include: "Intended to withstand or deter attack" and "performed to avoid risk, danger, or legal liability."

There are many see-saw categories of stocks. Some examples include consumer goods stocks or capital goods stocks, interest rate sensitive and non-interest rate sensitive, small cap or large cap. Sometimes a stock category can be further subdivided or it is different in more ways than one. Some stocks neatly fit a category and some do not.

The US economy is built on consumption. The consumer is king and is responsible for about 75% of the total Gross National Product. Although one can generally count on the US consumer to spend his money, when a down-turn hits the economy the consumer becomes choosy.

The consumer area is made of of two main categories, consumer staple and consumer discretionary stocks. Consumer staples are typically defensive stocks and consumer discretionary are much less so. The main idea is that the consumer is going to buy certain products or shop at certain places regardless of the economy. Some examples of consumer staples include Kroger (KR), Campbell Soup (CPB), Heinz (HNZ) and Clorox (CLX). Note that consumer stocks include a lot of food products but are not limited to food. Also note that all food stocks are not consumer staple stocks.

Almost every category of stocks include "see-saw" situations. For example, DRI and CKBL are food stocks. They operate such restaurants as Olive Garden, Red Lobster, Cracker Barrel and Logan's Road house. These food stocks are not consumer staples but instead are consumer discretionary. Again, the main idea is that if times get tough, consumers may not spend their money at a restaurant but they still have to eat. Kroger, Safeway and Winn-Dixie will achieve higher sales volumes of Cambells soup during tough times.

Many health care stocks are defensive. The older folks who use a lot of medicines buy them no matter if the economy is good or bad. On the other hand, elective eye surgery is not covered by insurance and sales volumes can really swing. This is where the term Beta comes into play. The consumer defensive stocks do not generally swing wildly in price. Aggressive stocks are cyclical in nature and go through wonderful business and terrible business years.

Goodyear Tire (GT), Reebok (RBK), Harley Davidson (HDI) and Time Warner Cable are examples of consumer discretionary stocks. However, one can make the argument that Cable TV is now a necessity or a consumer staple, especially for those who use cable for internet and telephone service. Similarly one can argue that Reebok will sell shoes in all economies but if it comes down to eating a meal or wearing new shoes the meal wins. Goodyear Tire is perhaps most interesting of all. Consumers have to buy tires when they wear out. However, this is one of the most cyclical businesses of all. I have purchased this company after three recessions and I have always made at least three times my money.

Goodyear fools folks for several reasons. First it is true that consumers can cut back significantly on tire purchases. In a tough economy they make fewer business and personal trips and they make sure they get a few extra thousand miles from each tire. The second surprise to investors is that the company is an industrial hose maker first, an aircraft brake maker second, a tire maker third and a shoe sole maker last. The business is much more of a capital goods business than most would guess. Even much of the tire profits come from the really big tires used on aircraft, machinery and in industrial applications.

Diversification is necessary because the whole story is more complex than anyone can fully understand. Relationships vary and even similar industries behave very differently. For example, today in the consumer staples area CVS and Walgreen (WAG) Pharmacies were up and Winn-Dixie, Kroger and Safeway were down. I do not know the reason but any one of these stocks is more volatile than the whole sector. If you buy 15 in the same sector, your portfolio volatility will be very close to the same as the whole sector. Being in the right sector is typically more important than picking the right stock but the skill and fun of picking the right stocks make investing interesting.

For the past 14 days, all sectors were down. However, consumer staples were down only .5 and health care was only down .9 whereas the technology sector (a high beta-aggressive sector) was down 5.7%. Again, this does not mean that every defensive stock outperformed all the other stocks in other groups. Comcast (CMCSA) was up 5.4% during this time and Walgreen WAG) was up 7.24%. Circuit City was down 12.12% and Winn-Dixie was down 16.84%. The more volatile stocks WAG and WIN were both consumer staples and the least volatile were both discretionary stocks.

I have stated that the correction we are experiencing is a rotational correction. Money is leaving the high flyers (look at the price of AMD, TASR, or SIRI) and is gravitating to lower beta stocks. PEP, WMT, WAG, and PFE. (Internet high flyers are generally holding up well).

An old stock market sage, PAPA JOHN, used to say that it takes a long time to turn a battleship around but once turned it is hard to stop. Others have said it makes no sense to try to catch a falling knife or to step in front of a moving freight train.

The main thing I would avoid right now is buying something because it is down in price from the first of the year! When you buy something now, you want to see relative strength. In other words you want to buy a stock that is going up faster or going down slower than other stocks.

Patience is needed when leadership is not clear. Some groups appear to have turned like a battleship. For example, Gold had a strong two year run but the group is down 12% in 30 market days. Small stocks also took a significant hit (check out the Russell 2000 index $RUT). Oil is perhaps the key. The commodity price keeps holding the 50 day moving average line and aggressive traders are taking both sides. Oil services have been hit pretty hard but the long-term solution to tight supplies is not in sight. The big integrated oils are defensive. They make their money and pay their dividends no matter what.

In a widows and orphans account, I would buy integrated oils, consumer staples and health care. In my aggressive accounts I am playing defense by holding and buying defensive positions, but I believe the second half recovery will ultimately be strong. Therefore I have purchased CAL and DAL and RDC. I am drilling for oil and operating airplanes at the same time. These are speculative positions but held in the context of a diversified portfolio.


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