Top Profit Plays for a Defensive-Investing Portfolio

William Patalon III

Prussian military theorist Carl von Clausewitz once said that "the best defense is a good offense." Although that bit of wisdom has been used everywhere from the battlefield to the gridiron, it could just as easily be deployed as part of a "defensive investing" strategy.

And in today's markets – whipsawed by worries emanating from virtually every major market around the globe – a defensive-investing plan needs to include protective stops, inverse funds, high-yielding dividend shares, "sin stocks, and investments in oil and other value-storing commodities," Keith Fitz-Gerald, the best-selling author who is Money Morning's chief investment strategist, said in an interview this week.

With the world markets in flux, Fitz-Gerald sat down with Money Morning Executive Editor William Patalon III to talk about defensive-investing strategies. What follows is the full text of that interview.

Q: Keith, there's an old military adage that says "the best offense is a good defense." From what you've been saying in the many conversations we've had, that really seems to apply to the stock market right now.

Keith Fitz-Gerald: Absolutely. But what many investors aren't prepared to contend with – even as they begin investing again with a newfound appreciation for the increased risk they now face – is that being defensive is not an all-or-nothing proposition. In fact, being "all in" or "all out" actually increases risk rather than the other way around. This is very counterintuitive, especially to investors who are foolishly attempting to "time" the markets.

Q: What exactly is "defensive investing?" How do you define it? How to you execute it? Is this the time to go defensive?

KF: To me defensive investing means paying careful attention to the risks you can tolerate – while still maintaining your upside. This begins with a cold, objective look at what mistakes you can afford to make. I talk to thousands of investors around the world each year, and I find that most have simply not asked themselves this question. On the other hand, if you have a clear understanding of your objectives, you can find ways to profit – even while investing defensively.

Is it time to be defensive right now? Yes – more than ever. No nation in the history of mankind has ever dug its way out on anything other than a short-term basis by debasing currencies the way central bankers are doing now. It may take some time for the final meltdown to occur, but we've clearly entered an era in which world stock markets – the U.S. markets included – cannot generate double-digit returns on a sustainable basis. I don't think many investors are set up for this financially or mentally.

Q: One bit of wisdom that you've imparted time and again is that investors need to protect their downside – but they also need to stay in the game for the long run, for that's where the volatility gets smoothed out and where compounding has the chance to work its magic. Can you elaborate?

KF: There's an old adage in investing circles that holds that the smartest investors make their money work for them – not vice versa. History shows us this is true. And that means leaving money alone to work its magic for as long as possible. That being said, it's important to understand exactly what I mean when I say "leave your money alone." I'm talking about what I like to call "buy and manage" – not "buy and hold," which, incidentally, I view as the greatest investing lie foisted on the American public in 200 years.

Investing is a process. And even though that may not work all the time, it does work over time – which means, in the "long run." Just because today's markets are very complicated doesn't mean investing has to be. In fact, the simpler the better.

In order to manage volatility you have to do two things right: First, you have to create a simple portfolio structure with built-in safety brakes, such as protective stop-losses; and, second, you should employ special "inverse funds" to smooth out the ups and downs along the way. These didn't exist until relatively recently, so many investors are still unfamiliar with them believe it or not – Money Morning readers excepted.

In terms of the inverse funds, two worth studying are the Rydex Inverse S&P 500 Strategy Fund ( RYURX) or the Rydex Inverse Government Long Bond Strategy Fund ( RYJUX). They both profit when markets go haywire. Incorporating these inverse funds into your overall portfolio will provide some important stabilizing influences that will enable you to stay in the game when the markets get dicey – even as other investors watch their financial futures get vaporized.

Various studies show that investing as little as 5% of your assets in such vehicles can remove 75% or more of a portfolio's overall volatility, while still preserving your income stream because they are not correlated to the broader markets. This is what I call "forward-looking allocation."

Q: Building on that last question, you've said that investors right now essentially need to hope for the best but still plan for the worst: Given what's happening in Europe – and concerns about so-called "sovereign debt" – what are the odds that we could be looking at an entirely new financial crisis? How could it play out and how bad could it get?

KF: There's no doubt in my mind that the problems leading up to this latest crisis are far from over. In fact, I think they're going to come back to haunt us, but I don't know when.

I have no idea how bad it will get – that depends on how successful Fed Chairman Ben Bernanke is in maintaining the illusion that the U.S. economy is getting healthier. In reality, all he's doing is using federal money to prop up the financial system, hoping he can do so long enough for the economy to heal. Central bankers around the world are involved in much the same strategies. It's almost criminal. You just don't wipe out those who have been prudent with their money in an effort to save those who haven't – yet that's exactly what he's doing.

It's interesting that Canada (Tuesday) became the first G-7 country to raise interest rates. We here at Money Morning have been saying for some time that Canada is one of the better-managed economies in the Western world. It doesn't hurt that the Canadian economy is backed by gold, oil and other hard assets.

I find it interesting that the people who favor the bailouts are generally traders, big bankers, academics and legislators. If you're big time, you get a bailout. If you're small time you get a hand out. The rest of us are just getting put out.

Q: What are some of the caution signals that you see flashing right now? You've mentioned LIBOR (London Interbank Offered Rate). What is LIBOR and what is LIBOR telling you right now?

KF: LIBOR is the rate banks charge each other to loan money. Theoretically, it's the best possible rate available because they are their own best customers. What most people don't understand, though, is that LIBOR is also an expression of risk.

When rates are rising – as they have been – it's a sign that banks don't trust one another, meaning, the cost of money is higher. Where this hits close to home is that LIBOR rates drive more than $350 trillion in derivatives and affect everything from the Prime Rate to credit card rates, mortgages and more.

LIBOR rose dramatically starting in mid-April and that tells me that banks are probably hiding a lot of skeletons in their closets, even at this stage of the game. Given the timing, my bet is that the vast majority of the problem assets are related to credit default swaps in Portugal, Ireland, Greece and Spain – the so-called "PIGS."

Just this week, in fact, reports state that LIBOR rates edged higher again, and noted that there's still a major reluctance to lend dollars to European banks. In fact, I saw a report this morning (Tues) suggesting that EU banks are hoarding over 300 billion euros instead of recirculating them into the financial system, which reminds me of what happened here in the U.S. just prior to the Lehman Bros. (OTC: LEHMQ) collapse.

Q: Anything else troubling you? I know you are very concerned about U.S. federal debt levels.

KF: Yes, I am because I have doubts about our ability to ever pay back this much money.

At the same time, however, I think it's important to point out that every significant crisis over the last 2,000 years has led to tremendous wealth-creating opportunities for those who are savvy enough to go hunting for profits when the days are darkest. So despite my personal feelings on the specific subject of U.S. debt, my overall investment viewpoint is one of incredible optimism. To be specific, let's refer to it as "opportunistic optimism." In fact, I may be more opportunistically optimistic now than I've been in a long time.

Q: How concerned are you about the European debt contagion? Could that spread to the U.S. market?

KF: I don't think it's a stretch to imagine the European contagion spreading here. If the EU cannot hold things together, attention will shift in short order to the rest of the PIGS, then to the United Kingdom, and finally to America, which is little more than a pauper in Emperor's clothing at this point.

Q: Even if that were to happen, however, you still believe investors would still need to have money invested … by that, I mean there still would be investment/profit opportunities to exploit?

KF: Most definitely. You miss 100% of the swings you never take.

Q: Can you offer some specific suggestions – not necessarily recommendations, since everyone has to look and see how these would match up with their personal goals, risk tolerances and strategies – for specific investments folks might want to consider? We've already mentioned inverse funds. How about real assets? And I know you've talked about "sin stocks?"

KF: You're in the right neighborhood. I think investing in real assets for the reasons I've just mentioned is a good start. So is the concept of buying sound currency. History shows that both of these things tend to do well when governments are printing money out of thin air, as they seem to be doing right now.

I'm a big fan of inverse funds because they can help hedge our returns when used properly.

Real assets figure to do well in the near term as a store of value – especially as central bankers degrade their own currencies by printing more and more of it. And in the long term – with great growth stories such as China and Southeast Asia setting the pace – the demand for such commodities will only grow. One area that we feel will experience in inexorable long-term gain is in energy, and that includes oil.

For a direct play on oil prices, you might wantto try an exchange-traded fund (ETF), such as the United States Oil Fund LP (NYSE: USO) or the iPath S&P GSCI Crude Oil Total Return Fund (NYSE: OIL). With this type of investment, however, here's a point that's worth noting. In the near term – with the U.S. dollar up and demand below where it's been in the past (and below where we expect it to be, incidentally) – "piling in" isn't a great bet, right now. I'd recommend that you average in, and take the time to build your position. After all, it's a position you're looking to hold for the long haul.

Q: How about "sin stocks?"

That is, these companies are thought to be insulated from economic slowdowns because most people don't view their "sins" as discretionary–in many cases they're addictions. In reality, sin stocks can enjoy temporary insulation from economic conditions, but they do generally suffer when economic conditions impair consumers' ability to spend. Over the long term, sin stocks perform well because consumers return quickly to their vices when the economy improves and spend aggressively during boom times.

KF: Right. Sin stocks fare better than other equities during downturns because a lot of folks don't see these types of expenditures as discretionary. Some analysts say these stocks benefit because activities such as smoking and drinking accelerate during tough, uncertain times. Either way, when the economy does rebound, folks can, and do, return to their "vices" quickly – and strongly.

I've also talked a lot about the value that good, strong "brands" will have in the economy of tomorrow. And these companies tend to have some great brands that inspire fierce brand loyalty.

The stocks worth looking at here would include Altria Group Inc. (NYSE: MO), and Diageo PLC (NYSE ADR: DEO). Both have top-drawer brand recognition in global markets but especially in Asian markets which are even now just coming into their own in terms of spending.

At the other end of the spectrum are Smith & Wesson Holding Corp. (Nasdaq: SWHC) and Sturm, Ruger & Co. (NYSE: RGR). I don't advocate violence, but the fact is that arms production certainly accelerates during uncertain times.

Q. How big a role do dividends play in an environment such as this one?

KF: Assuming you can hold onto the companies that produce them, dividend producers tend to be more stable than their non-dividend paying brethren and they tend to outperform them in rocky markets. Dividends also help investors substantially expand their holdings in down markets through dividend reinvestment – and that puts investors who favor them way ahead of the game when the markets eventually recover and stock prices rebound.

Q: We talked about commodities such as oil. What about such hard assets as gold? Any other hard assets?

KF: I expect all these things to be trading at far higher prices a few years from now. While I‘m never a big fan of buying into anything at or near all-time highs, there are bound to be corrections along the way that will prove to be super buying opportunities.

Q: How about China? And other overseas markets?

KF: Despite the fact that I'm a well-known China bull, I hold no illusions about its progress. There will be ups and downs as it evolves. Right now, for instance, Wall Street has concerns about a slowdown in manufacturing on the mainland. What's funny to me is that little more than a year ago, China was hardly a blip on most analysts' radar screens. Now, in the wake of the biggest financial crisis since the Great Depression, China is recognized as an "engine of worldwide growth and recovery" – which is why every hiccup now elicits terrible fear.

When it comes to China, what you need to remember is this: No matter what happens in the near term, in the long-term there is no single greater growth story on the planet. Investors who ignore this won't just miss the train … they'll spend years kicking themselves for it, too.

Q: It sounds like the real beauty of the defensive strategy you've outlined here is that it protects investors should the markets and the economy roll over – and yet, doesn't really penalize them should a more-bullish market return.

KF: You know as well as I do that there is no such thing as a perfect world. But there are strategies that can help us get close and the 50-40-10 portfolio strategy is one of them – especially when you combine it with tactical elements like protective stops and inverse funds [A related story about that portfolio strategy appears elsewhere in today's issue of Money Morning. For details on how to access it, see the editor's note that follows the story].

Q: Any other bits of wisdom that you'd like to impart?

KF: There is an old adage – not just about investing, but about life – that really applies here: "If you fail to plan, you plan to fail." I've found that most investors fail because they can't – or just won't – stick to a plan built around a simply defined set of rules. For some, this is a matter of reckless behavior in pursuit of profits – they like to chase the hot stock or hot trend of the day. For others, it's simply the constant switching between bad decisions and bad advice that dooms them to subpar routines.

But if you rely on yourself, and rely on a good plan, you'll find that you're a long-term winner. Now's as good a time to start as any. So take a deep breath, do your homework, and use our advice to craft a winning defensive game plan. You'll be thrilled with what you can achieve.

[Editor's Note: Money Morning's Keith Fitz-Gerald is still perfect.

And if you'd like to check out Fitz-Gerald's portfolio-strategy story, which appears elsewhere in today's issue of Money Morning, please click here.]

News and Related Story Links:

• Money Morning News Archive:
  Defensive Investing Stories
  
• Special Report:
  Chinese Real Estate: Four Ways to Profit From the Biggest Urban Migration in History
  
• Money Morning News Analysis:
  What Does Germany's Credit-Default-Swap Ban Mean for You?
  
• Investopedia:
  Buy and Hold
  
• Wikipedia:
  London Interbank Offered Rate (LIBOR)
  
• Reuters:
  LIBOR Steadies, Tensions Ease But Banks Still Hoarding
  
• MarketWatch.com:
  Canadian stocks, currency drop on rate hike, China worry
  
• Wikipedia:
  The Emporer's New Clothes
  
• eHow.com:
  A List of Sin Stocks?
  
• Investopedia:
  Protective Stop

William Patalon III

About the Author

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Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning. With his latest project, Private Briefing, Bill takes you "behind the scenes" of his established investment news website for a closer look at the action. Members get all the expert analysis and exclusive scoops he can't publish... and some of the most valuable picks that turn up in Bill's closed-door sessions with editors and experts.

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