Two Picks to Play Defense in a Slowing Economy

Nick Lanyi's picture

Wednesday, October 7, 2015 - 12:30pm

by Nick Lanyi

Is the economy slowing? Last Thursday the Institute for Supply Management (ISM) reported that its manufacturing index dropped unexpectedly; on Friday, employment growth was lower than expected. The strong dollar, which hurts exports, was partly to blame. But some economists think these negative reports are but two of many factors that point toward economic recession: slowing growth in China and other emerging markets, the specter of rising interest rates, dim prospects for corporate earnings this fall, evidence that corporate profit margins are falling, and even the rising power of anti-spending Republicans in the U.S. House of Representatives.

Granted, some of these factors are unlikely to impact the market at the same time -- notably, if the economy slows, the Fed may delay its long-planned interest-rate increases. But perception matters, and if more signals flash "slowdown" in the coming weeks and months, it will have an impact on investor decisions. As legendary investor Benjamin Graham said, in the short run the stock market is a voting machine. And it pays to be prepared if the votes seem to be tilting away from growth.

One way to cope with the risk of economic slowdown -- or the perception thereof -- is to make sure your investment portfolio includes so-called "defensive" stocks: high-quality, large-company stocks in sectors that hold up relatively well in recessions. Last week, I recommended two utility stocks that qualify and provide above-average yields. Today, I'll focus on three companies that also should help protect against a slowdown.

This Healthcare Giant Is On Sale
One of the classic defensive sectors is healthcare. People get sick regardless of what's happening in the economy, making healthcare products and services companies among the most "recession-proof" in the world. In addition, the aging Baby Boom population guarantees a rising number of seniors for the next few decades, and Americans 65 and over spend about three times as much on healthcare than the average U.S. adult. National healthcare spending is projected to grow at an average rate of 5.8 percent per year between 2014 and 2024, according to the U.S. Centers for Medicare and Medicaid Services.

The healthcare sector contains a diverse array of stocks of all sizes and risk profiles, from aggressive microcaps to the bluest of blue chip large caps. We'll lean strong toward the latter in search of defense against economic slowdown. And one of the classic healthcare defensives happens to be on sale now: Johnson & Johnson (NYSE: JNJ).

One of the largest companies in the world by market cap, Johnson & Johnson boasts an enviable range of top brands and products in pharmaceuticals (about 40% of revenue), medical equipment (about 40%) and consumer products (about 20%). Most of its products are defensive in nature, especially the consumer business' household brands such as Band-Aid, Tylenol, Neutrogena and Acuvue. The company's pharmaceutical pipeline is solid, as well.

JNJ is financially rock-solid, with $34 billion in cash on its balance sheet and manageable debt; the company's AAA- rating makes it one of only three that high. That means J&J easily could make strategic investments in fast-growing areas of healthcare while continuing to buy back shares and raise its dividend.

J&J's earnings per share (not counting one-time adjustments) have grown for 31 straight years and its dividend has risen for an astounding 57 straight years. At current levels, the stock trades at a cheaper-than-reasonable 15.4 times analysts' consensus estimate for 2015 earnings per share and pays a healthy 3.0% dividend yield. The stock is trading 13.5% below its 52-week high of $109.49.

These Consumer Staples Rivals Make Timeless Investments
Another classic defensive industry is the consumer staples sector. As with healthcare, these companies sell products that one needs regardless of what's going on in the economy, or even in a particular household: food, drinks, cleaning products, etc. Here again, I'll focus on the highest-quality companies. One great example is Coca-Cola (NYSE: KO), owner of one of the world's best-known brands and a diverse beverage portfolio that generate ample cash flow from markets around the world. It's trading at an average valuation relative to its own history and is a solid choice to help weather an economic slowdown.

But I actually prefer PepsiCo (NYSE: PEP) now, because its beverage business -- which includes soft drinks such as Pepsi and Mountain Dew, water brand Aquafina, Tropicana fruit juices and Gatorade sports drinks -- is complemented by a food business, led by Frito-Lay and Quaker, that actually makes it the largest snack company in the world and gives it the capacity for higher earnings growth.

One of the best-managed consumer products companies, PepsiCo has diversified into faster-growing and healthier food and drink products over the past two decades, such as hummus maker Sabra (Pepsi owns half the company). It also has remained in touch with new consumer trends, as exemplified by its partnership with SodaStream (Nasdaq: SODA), which allows customers to create their own Pepsi drinks at home.

PepsiCo stock yields 2.9% at today's prices; the company has raised its dividend for 42 straight years and has the capacity to keep doing so, with a payout ratio of only 61% currently. The stock currently trades at a reasonable 21.1 times analysts' consensus estimate for 2015 earnings per share and about 5% below its 52-week high of $100.76.

Risks To Consider: If the economy unexpectedly picks up steam, investors may favor cyclical stocks over these defensive offerings.
    
Action To Take: If defensive sectors are underrepresented in your portfolio, consider adding two or three of these high-quality gems. Buy Johnson & Johnson (NYSE: JNJ) below $98 and PepsiCo (NYSE: PEP) below $99.

P.S. We've uncovered eight elite -- yet little-known -- that returned more than 300% on average in the past decade; more than 3x the S&P's total return. But the best news -- their upside is only just beginning.  Get the names of each of these stocks by accessing our new report here.

Nick Lanyi does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.