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In recent weeks many pundits and gurus have advised investors on which defensive stocks to buy for portfolio protection - but before following their lead, you should do some research as well.
The definition of defensive stocks seems to be a little unclear, but generally the same names keep appearing: large drug stocks, consumer-related issues and utility companies. While those suggestions sound like smart moves, many of these advisors seem to be using a rearview mirror to select which stocks and sectors fir the definition of "defensive."
In fact, during the past year the dividend-paying large cap stocks have had a huge rally as yield-seeking investors have pushed them to new highs. They are exactly the type of stocks that a defensive investor would want to avoid in the current market.
Fortunately for investors there is a method for identifying and selecting truly defensive stocks that has worked for more than 40 years.
In 1972 edition of the "Intelligent Investor," Benjamin Graham outlined the characteristics of defensive stocks.
Graham suggested that investors should buy companies with substantial revenues, strong balance sheets and a long history of profits and dividends. He further suggested that investors look to pay less than 15 times earnings of 1.5 times book value for these issues to treat a greater margin of safety. If the earnings ratio was extremely low one could afford to pay a little higher multiple of asset value but in no case should the factor of the P/E ratio multiplied by the price-to-book ration exceed 22.5.
This simple strategy has been tested by academics and investment practitioners over the past four decades, This approach has been clearly demonstrated to not only offer some measure of protection against stock market fluctuations but has outperformed the broader markets by a wide margin. Although no method can entirely escape market forces this approach seems to fare well.
Now, something to note about this approach: When we search for these defensive issues one observation becomes apparent almost immediately. Right now a search of the entire universe of stocks covered by the Value Line Investment Survey turns up just six issues that qualify. Six months ago, when the S&P 500 was more than 8% lower, there would have been a handful more.
Graham's method suggested a diversified portfolio with at least 10 stocks - or as many as 30. While the following six suggestions give a nice mix of industries and sectors, there aren't enough of them to fill out a fully diversified portfolio that follows Graham's method. Many defensive investors will likely choose cash as a substitute for the remaining defensive stocks.
Here are the six that fit into Graham's method of choosing defensive stocks to buy:
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