How To Build A Defensive Portfolio

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Includes: AAPL, DIS, JNJ, KO, MCD, MRK, MSFT, PEP, PFE, PG, WMT, XOM
by: Motif Investing

Summary

The overarching theme to building a defensive portfolio is to focus on high quality companies with strong cash flows, reasonable valuations, and a solid history of operation.

When the market experiences a downturn, you want to own companies that have the highest chance of withstanding the storm.

Cash and CDs are the most defensive instruments, but over the long term, they tend to lose purchasing power.

Blue-chip stocks and government bonds are two of the sturdier asset classes if your goal is to build the strongest defensive portfolio possible.

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With a rough start to 2016, a lot of investors are considering building a defensive portfolio with the main goal of minimizing risk and loss of capital. If we include 2009, the bull market is now entering its 8th year. How long can the good times last? Nobody knows. But after a flat 2015, many investors are looking to get more conservative.

With China's stock market getting halted twice this week, fears of global contagion might spread as a result.1 Principal preservation has come to the forefront of many investors' minds.

Various Levels Of Defensive Portfolios

There are many different routes you can take to help protect your money when the stock market is a bit dicey. Let's take a look at a range of several options you might want to consider.

All Cash Portfolio. The most defensive portfolio is one that contains 100 percent cash. Unfortunately, cash is also highly likely to lose purchasing power given the returns on cash are generally lower than the rate of inflation - usually anywhere from 0.5%-2%.2

But given the S&P 500 was down 0.71 percent for 2015, cash outperformed stocks. However, if we are to include dividends, then the total return on the S&P 500 was roughly 1.2 percent in 2015.3

CD Portfolio. If you're looking for principal protection while trying to beat inflation, then another idea could be to hold Certificates of Deposit. CDs often come in 6-month, 1-year, 2-year, 3-year, 5-year, 7-year, and 10-year terms.

High-Quality, Blue-Chip Stocks. Companies that are prone to get hit the hardest during difficult economic times tend to trade on high valuation multiples and/or have weak earnings, weak cash flow, or no earnings. Think about the typical high-flying dotcom company like Pets.com or Webvan.4 They quickly went out of business after the NASDAQ started to collapse in March 2000.5 Speculative companies that do not have enough earnings to be self-sustainable tend to get sold off aggressively.

On the other hand, companies, which have strong cash flow, a long history of operations, and are reasonably valued compared to the overall market (S&P 500) are likely to be less volatile during difficult times. The Dow Jones Industrial Average of 30 companies are all considered blue-chip names. Examples include Procter & Gamble (NYSE:PG), Exxon Mobil (NYSE:XOM), Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL), Disney (NYSE:DIS), Merck (NYSE:MRK), etc.6

Defensive Companies With Strong Cash Flow. Even among the blue-chip names, each company has different qualities based on its industry and fundamentals. For example, with oil prices collapsing, blue-chip companies such as Chevron (NYSE:CVX) and Exxon Mobil may have a tough time performing compared to Disney, which bought Lucasfilm for $4 billion,7 and is on pace to make well over $1 billion from the latest 'Star Wars' film alone.8

Some Wall Street defensive company examples include Proctor & Gamble, Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), Wal-Mart (NYSE:WMT), McDonald's (NYSE:MCD), Johnson & Johnson(NYSE:JNJ), Pfizer (NYSE:PFE), and utilities companies.9 The idea is that consumers still need to eat, drink, wash, take their medicine, and use electricity. Just bear in mind that defensive sectors such as consumer staples, food and beverage, and healthcare may still experience declines in value during market corrections even if their earnings continue to grow.

You may also want to consider scaling back on consumer discretionary stocks since those products tend to lose appeal when people are worried about their income and jobs. Consumers typically have less desire to buy items like a Louis Vuitton (OTCPK:LVMUY) handbag, book vacations through Expedia (NASDAQ:EXPE), or drive a $60,000 automobile made by BMW (BAMXY) during economic declines.

Conservative Asset Allocation. After deciding which defensive stocks and industries you think could perform best, perhaps the most important determination to a defensive portfolio is constructing a defensive asset allocation. Three common investment classes that typically make up an asset allocation include stocks, bonds and money market investments. How much you allocate to each class can alter the risk profile of your portfolio.

Stocks have higher returns than bonds, but also higher risk. Bonds have traditionally lower returns than stocks, but have the benefit of less risk. A few examples of asset subclasses and alternatives are listed below.

U.S. Treasuries: Issued by the United States Department of the Treasury, these types of bonds are generally considered to be the least risky.

Municipal bonds: Debt issued by states, cities or other local government entities are commonly known as munis. These debt instruments help finance municipal activities and projects.

Corporate bonds: Corporate bonds typically have maturities of one year or longer. Corporate debt with maturities under a year is known as commercial paper. Bonds issued by companies with high credit ratings are referred to as investment grade or high grade, rated BBB and higher.

Large-cap stocks: Companies with market capitalization typically over $10 billion.

Mid-cap stocks: Medium-sized companies that generally have a market cap between $2 billion and $10 billion.

Small-cap stocks: Typically lower liquidity, higher risk equities with a market cap below $2 billion.

When you're determining your target asset allocation, aim to maximize return and minimize risk. The chart below illustrates how different asset classes vary in their risk and return profiles.

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Source: Investopedia

One conservative asset allocation example for a 30-year-old is to have a portfolio constructed of 70 percent stocks and 30 percent bonds. Instead, investors in that age group may want to consider shifting 50 percent of their portfolios into municipal bonds and U.S. government bond funds. The remaining 50 percent could be used to buy blue-chip companies in the consumer staples and utilities sector.

Here are some examples of conservative and moderately conservative asset allocations and how they contrast with an aggressive one.

Conservative Portfolio moderately conservative

Progressive Portfolio

Source: Investopedia

Rebalancing. A defensive investment strategy entails regular portfolio rebalancing to maintain one's intended asset allocation. To help protect your portfolio against significant losses during major market downturns, you may want to consider high-quality, short-maturity bonds and blue-chip stocks; diversifying across both sectors and countries; placing stop loss orders; and holding cash and cash equivalents.

Readers, what actions are you taking to protect your money this year?

  1. Bradsher, Keith, Amie Tsang, "China Halts Trading After Market Tumbles More Than 7 Percent," The New York Times, January 6, 2016.
  2. Hilsenrath, Jon, "After 'Close Call' to Raise Rates, Fed Starts 2016 With Debate On Pace," The Wall Street Journal, January 6, 2016.
  3. Google Finance, "S&P500," Google Finance, 2016.
  4. CNET Staff, "Pets.com Latest High-Profile Dot-com Disaster," CNET, January 2, 2002.
  5. Sandoval, Greg, "Webvan Delivers Its Last Word: Bankruptcy," CNET, September 7, 2007.
  6. CNN Money, "Companies In The Down Jones Industrial Average," CNN Money, January 6, 2016.
  7. Leonard, Devin, "How Disney Bought Lucasfilm - And Its Plans For 'Star Wars,'" Bloomberg Business, March 7, 2013.
  8. Pallotta, Frank, "'Star Wars: The Force Awakens' Makes $1
  9. Billion In A Record 12 Days," CNN Money, December 28, 2015.
  10. Harding, Sy, "Defensive Sectors Are No Help In Market Downturns," Forbes, May 9, 2014.