Defensive shares can be a good bet when stock markets are suffering.
Tough economic times call for major investment decisions. Yet just because stock markets remain volatile doesn’t necessarily mean you should desert shares altogether. Indeed, if you’re prepared to stay in for the medium to long haul, a portfolio of ‘defensive’ stocks, paying stable dividend income, could prove rewarding.
A defensive stock is typically defined as one that provides stable earnings and dividend payouts, irrespective of where the economy is at in the business cycle. So even if stock markets are suffering, defensive shares should do ok. At least, that’s the theory.
On the basis that everyone needs to eat, clean, wash, and take their medicine, firms operating in the food, household products, pharmaceuticals, water and energy sectors are obvious targets.
Candidates such as Tesco (LSE: TSCO), Unilever (LSE: ULVR), United Utilities (LSE: UU.), GlaxoSmithKline (LSE: GSK), BG Group (LSE: BG.) and National Grid (LSE: NG.), all share in common robust balance sheets, strong positions in their respective markets and, in theory, adequate dividend cover to maintain their dividend payouts.
Are you covered?
Dividend cover is an important consideration if you’re looking for stable income from the shares in your portfolio. Defensive stocks don’t usually provide the biggest payouts and whilst tending to outperform in weaker markets, often underperform in stronger ones. Such caveats, however, should be counterbalanced by the strong balance sheets these companies offer.
Dividend cover is a measure of a company’s ability to maintain the level of dividends it pays out. The higher the level of cover -- a minimum of 2 to 2.5 times is desirable -- the greater the ability to maintain payouts should a company’s profits drop.
Worth pointing out however is that a low level of dividend cover can be acceptable in a company with very stable profits, but that the same level of cover at a firm with volatile profits could indicate that dividend payouts are at risk.
If, for example, the dividend cover is 3, the firm's profit attributable to shareholders is three times the amount of dividend paid out. The formula for dividend cover is Earnings per share (EPS) ÷ Dividend per share (DPS).
One share to tuck away?
At first sight the inclusion of Lloyds TSB (LSE: LLOY) in a defensive portfolio isn’t an obvious one, given it’s in a well documented bombed-out banking sector that has write-downs issues across the board and recently witnessed apathy to the point where HBOS (LSE: HBOS) received acceptances for just 8.3% of the shares on offer in its rights issue, leaving 1.375bn shares looking for a home.
It also doesn’t have the geographical diversification --- affording some measure of protection -- that many typical defensive stocks have.
However, its lack of exposure to the US sub-prime mortgage market means it doesn’t face the scale of write-downs now being seen by many of its competitors. Nevertheless, it did write off £387 million before tax in the first quarter as asset-backed investments on its balance sheet were impacted by turmoil in the credit markets.
In addition, there are potential problems further down the line with a £350bn loan book in mortgages and corporate lending highly exposed to the commercial property sector.
That said, the bank’s balance sheet has remained strong enough to be able to withstand the turmoil seen elsewhere in the sector where competitors have been forced to generate additional cash to repair their balance sheets via rights issues and the like.
True, being the most UK-focused of the nation’s major banks, LloydsTSB will likely face increased debt delinquency as the credit crunch bites domestically. But it continues to maintain adequate dividend cover allowing it to pay a full year of dividend of 35.9p per share, giving a whopping yield of 11.3%.
Moreover, its relative lack of diversification will be a help, rather than a hindrance, unless the UK economy goes into freefall -- an unlikely event in my view.
If you are looking to set-up a portfolio of defensive stocks, the following points are worth considering.
1. Does the company satisfy the eat, sleep and wash rule?
2. Does the company have a good growth story to tell?
3. If the company has a good growth story to tell and continues to pay a high dividend, does it have adequate dividend cover?
4. Reduce your risk by diversifying your portfolio across different sectors.
5- If you are less concerned about taking income consider reinvesting your dividends as this will enhance overall performance over time. Many companies have dividend reinvestment schemes.
Good luck!
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