How to find the best defensive stocks

Investing is about the future – future share prices, future earnings and future dividends – and that’s where the problems really begin because predicting the future is hard.

But don’t let that put you off because it’s not like we live in a world of pure randomness.  For example, if I say that the sun will come up tomorrow, I’m very, very likely to be right (even if I can’t see it because of all the clouds).

So we have a world in which some things are very likely to happen (the sun coming up tomorrow), some things are very likely to not happen (a giant squid destroying New York), and almost everything else fits somewhere in between.

What does all this have to do with investing in defensive stocks?

Good question.  The answer is that defensive stocks are consistent performers and:

In the stock market, risk, return and consistency are all closely related

Let’s take a look at two hypothetical companies.  The first one sells toothpaste, while the other sells bright red yo-yos.

Over the past ten years, both companies have grown their revenues, earnings and dividends by 100%.  At their current share prices, both companies have the same PE ratio and the same dividend yield.  With just that information, it’s hard to come to any conclusions as to the relative attractiveness of each investment.

Things become a bit more interesting when we look at the earnings for both companies in the chart below:

Of course, this is a slightly artificial example, but there are plenty of companies out there that look like either one of those plots.

If you’re looking to invest in defensive stocks like the toothpaste company, you should be able to make some reasonable guesses about possible future earnings.  The main assumptions would be that the world still needs toothpaste and that this company can continue to compete effectively.  History would suggest that both those assumptions are reasonable, although, of course, some additional investigation would be required.

The story for the yo-yo company is entirely different, and it goes like this:  In 2006, some trendy kids started buying red yo-yos and started a new, underground trend.  By 2009 it had hit the mainstream, with celebrities and eight-year-old girls jumping on the bandwagon.

Alas, as is often the case with these trends, they don’t last, and so today, the yo-yo company’s earnings have fallen a long way from their peak.

For investors, the question is the same as always – what is a reasonable assumption for the future?  What can I say about the yo-yo company’s earnings in the next few years?  I’m interested in the next few years rather than just next year because events over one or two years are effectively random, as are share prices.

The answer is that it’s very hard to say anything about the yo-yo company’s future earnings.  Will they go back to 100?  Will they go back below 50 as they did in 2006?  Will they average about 180 as they did in the previous decade?  Will yo-yo practitioners around the world turn to roller skates instead, causing the yo-yo company to go bust?

What I’m getting at is this:

Consistency is desirable for long-term investors

Looking for consistency is one of the best things you can do to reduce risk.  It isn’t a magic bullet, and it doesn’t guarantee that an investment will be low-risk or safe, but it’s a sensible place to start your search.

Although I use the term ‘defensive stocks’ to describe these highly consistent companies, that doesn’t mean I’ll exclude cyclical businesses from my research.  If a cyclical business has a long enough cycle so that it is consistently growing for a decade, that’s still a defensive stock in my book because my time horizon for each investment is typically going to be less than ten years.

Measuring consistency

Until recently, I didn’t have a method for finding consistent companies.  I was limited to looking at the 10-year history of revenues, earnings and dividends by eye and making a judgement about how consistent they looked.

However, more recently, I’ve developed a new way to measure consistency which is based on the numbers rather than my ‘eye’.

The Consistency rating in detail

Following on from my previous look at measuring a company’s growth, the consistency rating is also based on the company’s 10-year history of revenues, earnings and dividends.  For me, these are the three most important figures to look at when doing the initial review.

Consistent profits

You’re unlikely to find a strong, consistently growing company that doesn’t earn consistent profits.  So the first thing to check is how consistently the company has earned a profit in the last decade.  In this case, I’m measuring profits as basic earnings.  For every year that the company makes a profit, it gets a point.

Consistent dividends

With this defensive value investing strategy, we’re trying to maximise the returns from all available sources, which includes earnings growth, changes to the PE ratio (or PE10, to be precise) and dividends.  For dividends to be a good source of returns, we need them to be consistently paid out every year.  So again, the company gets a point for every year in the last decade where dividends were paid out.

Consistent growth

Consistent profit and dividends are a good starting point, but we want our investments to grow over time (remember, earnings growth is one of the key drivers of shareholder returns in the long term).  This means that we have to pay attention to the growth of profits and dividends, not just whether they exist or not.

What we need is a measure of the consistency of growth which would highlight the toothpaste company rather than the yo-yo company.

Consistent revenue, earnings and dividend growth

For each of these key numbers, I have a simple way to check for consistent growth.  For each year in which revenues hit a new high, the company gets a point.  The same goes for earnings and dividends.

Unlike the measure of consistent profitability, which uses basic earnings for consistent growth, I look at adjusted earnings.  This is because basic earnings tend to be more volatile, and this can mask the underlying progress a company may be making.  Although adjusted earnings have their own problems, like any financial number, I think they’re a better measure when looking for consistency.

So in the example above, the toothpaste company had ten years of record adjusted earnings out of 10, while the yo-yo company only managed three record years (2003, 2008 and 2009).

In total, there are 50 points available for consistency.  10 for each year of profit, 10 for each year a dividend was paid, and 10 for each year of record revenues, earnings and dividends; and because percentages are generally more intuitive, I turn the score out of 50 into a percentage.

Four steps to a defensive value stock screen

Over the past few weeks, I’ve covered each of the four metrics which make up my defensive value screen.  Each one is designed to highlight a key feature that all high-quality, defensive value stocks should have.

Two fundamental factors

There are two fundamental factors that I’m interested in.  These two factors are independent of the share price and are affected only by the economic output of the company.

The first one is the amount of long-term growth that a company is able to generate.  All else being equal, a higher long-term growth rate is better.  Just look at how much money Buffett has made out of Coke rather than the Nebraska Furniture Mart.

The second fundamental factor is the consistency of that growth.  Spectacular growth in just a handful of years is difficult to forecast in the future and unreliable.  Companies that are able to grow consistently in most years are more likely to keep doing so in the future.  However, I don’t have a hard cut-off, like saying that a company must have grown every year or 9 out of 10 years, I just prefer more consistent growth rather than less.

Two Valuation factors

There are also two valuation factors that I’m interested in.  It’s no good finding a company with outstanding fundamental factors, such as a 20% annualised growth rate and a consistency rating of 100%, if the share price is sky-high.

For an example of this, find the annual reports of Vodafone from 1999 to today and then look at a chart of the share price over that period.  That’s what a high share price can do to future returns, even if the underlying company does well.

The first valuation factor is PE10, which is the share price to 10-year average earnings ratio.  I’ve written about this repeatedly over the years, most recently in relation to what is and isn’t a good time to invest in the stock market.

The same logic that applies to valuing the market also applies to robust and defensive companies.  By using the 10-year earnings average as a measure of value rather than the one-year earnings, as most people do, you get a much better, more predictive valuation ratio than the simple PE.  In other words, PE10 tells you much more about likely future returns than the simple PE ratio.

The second valuation factor is the dividend yield, which I covered again in how to find the best high-yield shares.  Dividends are an important part of total returns to shareholders over periods of five years and more, and given that all investors should have a time horizon beyond five years, they should be important to almost all investors.

Next time I’ll work through some applied examples, showing the difference between good companies and mediocre companies.  I’ll also look at good defensive stocks and bad defensive stocks from a valuation point of view and why good companies aren’t always good investments while mediocre companies aren’t always bad investments.