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The markets have pulled back and the VIX has spiked…what now? Before you run out and sell your portfolio in a panic, consider hedging with Puts, picking up some leveraged short funds, adding a couple short-sell positions to your portfolio on weak stocks, or switching a few of your higher beta picks over to a defensive utility sector. It is this last point we will now discuss.

Going Defensive Graham-Style

Benjamin Graham is known as one of the fathers of value investing. His stock selection methods favored holding companies for incredibly long periods of time, perhaps forever. His defensive companies were not small caps, in a sector such as utilities, stable earnings and dividends, and a growth rate - even if very slow. The price to earnings ratio needed to be moderate (below 15 in this instance), and a reasonable price to book ratio(PE x PB less than 22). I’ll also require an increase in dividends over the past 7 years.

Below are the stocks that make the cut and their yields.

Company

Ticker

Market Cap (mil)

Yield

NextEra Energy, Inc.

(NEE)

23047.1

4

Edison International

(EIX)

12201.6

3.4

Consolidated Edison, Inc.

(ED)

14513.8

4.8

Dominion Resources, Inc.

(D)

26829

4.3

Avista Corporation

(AVA)

1295.6

4.9

AGL Resources Inc.

(AGL)

3019.4

4.7

NEE – The 5 year dividend growth rate has increased an average 7.1% over the past 5 years. This gives the stock a 5 year price to dividend multiple of 30.3. If you use the forward annual dividend rate of $2.2 and multiply this by the 5 year dividend ratio of 30.3, the share price could see increased valuations up to $66.66 if defensive stocks are turned to in mass numbers as a protection against a correction. Of course, even if prices stay below $55, a 4% yield is decent if prices remain firm.

EIX – The 3.4% yield is the lowest on the list and cash flows are in need of a comeback. Still, paying out dividends in all seasons and a payout ratio listed at 33%, they definitely have room to keep paying good yields in bad seasons. The average price to dividend ratio over the past 5 years is 32.3 and based on the 1.28 future dividend the share price could be valued up to $41.34 if this particular sector received favorable attention.

ED – Again, it would be nice to see a little more free cash flow per share, although revenue and earnings are expected to climb up at better rates than the past 5. When looking at dividend to price multiples, this stock is actually trading above its 5 year average. The expected $2.4 dividend times an 18.9 (5 year average) gives this a $45.36 sticker price. Even when using historical PE or sales, this stock seems to be slightly above historical valuation metrics.

D – Another negative free cash flow stock. Although sales are down over the past 5 years, earnings are way up. This is partly due to net profit margins being over 3 times higher than they were 5 years ago. The payout ratio is only at 38% giving this more room to climb if necessary. It is trading just a couple of dollars shy of its future dividend x 5 year average ratio which works out to $48.07. Again, this is sort of like a forward PE ratio but with dividends and historical averages.

AVA – I am happy to see a stock back into the free cash flows. The next 5 years expect an annualized 4.67% earnings growth, which beats the recommended 3% by Graham. All margins have generally increased over the past 3 years. Even as share prices fell, the company kept increasing dividends thus jacking yields up. Payout ratio is still only at 60%. Using the forward dividend multiplied by the 5 year average price to dividend ratio of 27.8, this stock has an average valuation of $30.58. With share prices at $22.50 this is a bargain.

AGL – the last stock on this list is fairly valued looking at dividend calculation. I payout ratio of 59% gives this a margin of safety for continued dividends. Gross, operating, and net profit margins are all up over the past 3 years. Free cash flow is still negative overall. Growth is expected at over 5% over the long-term, and the analysts have a low standard deviation. Lower dispersion usually relates to better average forecasting.

Is Now the Time to Go Defensive?

All too many times the market has led us to believe that a major correction was due, and then it sprung into action for its next bull leg up. While I’m not saying that right now is the time to go ultra-conservative on your portfolio, it might be time to lock in profits for your higher-beta picks and stick to safer stocks if you are very conservative. If we shoot past this consolidation to new highs on the SPY, you might want to look at those growth picks again.

What’s your take? Are we entering a correction again? Or are the Chicken Little’s of the market creating undue panic? What’s your strategy right now? Please post and let others know your technique and picks.

Source: Is It Time to Go Defensive With These 6 Graham Stocks?