Defensive Stocks?

Companies like Procter & Gamble (PG) and Johnson & Johnson (JNJ) are usually referred to as "defensive stocks". Well, as it turns out, that's not really the case. Well, at least based upon their returns over the past 20-years. The word "defensive" implies more modest overall returns as a trade-off for more downside protection.

In fact, those two stocks (and others with similarly durable economic characteristics) historically have had higher long-term overall returns combined with their defensive characteristics.

Stock                                         |20-Year Return
Procter & Gamble (PG)      |   728%
Johnson & Johnson (JNJ)|   785%
Coca-Cola (KO)                     |   580%
Pepsi (PEP)                             |  612%
Altria (MO)                             |   616%
Hershey (HSY)                      |   408%
General Mills (GIS)              |   283%

S&P 500                                   | 177%
Source: Yahoo! Finance

The returns posted above include only the capital gains portion of the 20-year return. Include the dividends and the return is actually much higher. As a result, the above naturally understates the performance gap since the dividends these companies pay are typically bigger than an index fund based upon the S&P 500. The bottom line: many of these companies have historically outperformed over the long run at lower risk for the simple reason that they are higher quality businesses.

Well, at least that is my view.

Durable high returns on capital matters a whole lot in investing.

Generally, these businesses tend to have it. My preference happens to be Philip Morris International (PM) -- spun off from Altria in 2008 -- and Diageo (DEO) but certainly others could be attractive if bought at the right price.*
(I did not include the 20-year returns of PM and DEO above because neither have been trading as separate marketable stocks long enough.)

I've also included two stocks above I don't really follow closely, GIS and HSY, as examples. GIS and HSY also outperformed the S&P 500.

In fact, though there are always exceptions, it is difficult to find shares of businesses that make and distribute leading small-ticket consumer branded products (or FMCG) on a big scale that did not outperform over those 20 years.

Check this over other long-term time periods (~15-20 years or more). I think any objective look at this will reveal that many -- even if not all -- shares of these higher quality businesses produced above average risk-adjusted results over many longer time frames.
(Over the shorter run -- less than five years or so -- anything can happen as far as relative performance goes, of course.)

Well, especially if bought when they were selling at a nice discount to intrinsic value but, at the very least, at a reasonable valuation. What may be a smart buy at a plain discount to value isn't at some higher premium price no matter how good the business may be.

Also, as with any business, whether management is capable of sustaining and even increasing the "economic moat" matters a whole lot. As is competent capital allocation. These are elements of intrinsic value that are hard to measure yet still very real.

Of course, what ultimately matters is how these businesses and their shares perform going forward. Getting that at least mostly right still requires plenty of work.

In other words, just because something that seems to be a higher quality investment has done well in the past guarantees nothing.

"If past history was all there was to the game, the richest people would be librarians." - Warren Buffett

Still, at a minimum, the above at least suggests that those who know how to judge business value could: 1) take "inventory" of leading small-ticket consumer brands in use everyday, 2) buy the corresponding stocks at a fair price (or, better yet, when they're occasionally selling at a plain discount to value), 3) hold them long-term, and 4) achieve more than satisfactory risk-adjusted results.

Minimal trading required. Minimal frictional costs.

The average mutual fund underperforms the S&P 500. According to Vanguard founder John Bogle, from 1984 to 2002 mutual funds on average delivered a 9.3% annual return compared to the S&P 500's return of 12.2% a year.**

"The reason for that lag is not very complicated: As the trained, experienced investment professionals employed by the industry's managers compete with one another to pick the best stocks, their results average out. Thus, the average mutual fund should earn the market's return—before costs. Since all-in fund costs can be estimated at something like 3% per year, the annual lag of 2.9% in after-cost return seems simply to confirm that eminently reasonable hypothesis." - John Bogle

Some professionals (often via various business news media outlets) seem to suggest jumping in and out of shares in excellent businesses like Coca-Cola based upon whether a defensive posture is warranted. 

Well, correctly doing this without making mistakes (and creating unnecessary frictional costs) seems like a good idea mostly in theory. In fact, there's plenty to suggest this might be less than a brilliant approach. It's not just that the average mutual fund underperforms. It's worse than that.

Here's what Jack Meyer, who managed the endowment, pension, and other assets as President and CEO of the Harvard Management Company from 1990 to 2005, had to say:

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value. The investment business is a giant scam."

Of course, there are more than a few exceptional professional money managers with proven track records but, in the real world, it's just not easy to identify who'll outperform in the future.

Investors add complexity and risk to the investing process that often isn't necessary.

For many reasons, shares of these and similar higher quality businesses seem unlikely to perform nearly as well on an absolute basis in the future. Maybe that's a conservative view. Maybe not. In addition, judging value well and buying them at a plain discount to intrinsic value (i.e. with a margin of safety) still, as always, matters a bunch. Again, what's sensible at a plain discount to intrinsic value doesn't make sense at some materially higher valuation.

If, in fact, bought well, the relative risk-adjusted merits for the best of these seems likely to remain, in the long run, not insignificant.

It can be a simple (if not necessarily easy) but effective means of producing attractive long-term results.


* Long positions in PG, JNJ, KO, PEP, MO, PM, and DEOThese are stocks I consider attractive long-term investments if bought at the right price for my own portfolio. In other words, I never will have an opinion as to what others should or should not be buying or selling. My judgment may also turn out to be very wrong, of course. Going forward, I happen to think that both PM and DEO have very attractive business economics and durable advantages that are at least as good as most "defensive stocks" (and likely better than some of the others listed above). I don't think the reputation for these being defensive stocks is incorrect, it's just incomplete. Yes, defensive stocks usually have less than exciting price action and volatility and are likely to do better in bear markets. Yes, they're also likely to not do particularly well in bull markets. Anyone buying these stocks expecting them to outperform during the next bull market is likely to be disappointed. That is, in part, how they have earned the reputation of being defensive. Yet, this defensive reputation is verifiably incorrect when you look at their historic returns over the longer haul. So it's when they're looked at over longer time frames (more than a full business cycle or two) that the picture becomes more clear. Long-term offense and defense. Higher quality businesses. Of course, like any investment, they've still got to purchased with a margin of safety. Many of these seem not particularly expensive at all in April 2009, but who knows if that persists. As with any business, a healthy balance sheet still matters but, generally speaking, the best of these tend to have more than respectable financial strength. Capable management and wise capital allocation naturally also matters. Even if shares of the higher quality businesses did not outperform over the long haul going forward (and they may not, of course), the sheer simplicity of the approach compared to alternatives needs to be considered. So does the reduced likelihood of permanent capital loss and more narrow range of outcomes. In fact, if the quality franchises produced merely market returns they'd still win in my book. The reason is that, if bought well, the same return will have been arguably achieved at less risk of permanent capital loss (not temporary paper losses). 
** This study was limited to mutual funds. Some might wonder how hedge funds have performed long-term. Here's a paper by Burton Malkiel and Atanu Saha that provides some insights on hedge fund risk and returns.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice.
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Defensive Stocks?
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