What To Hold If You're Afraid Of An Upcoming Bear Market

Summary

• Bear markets cause traumatic experiences to investors.
• Too many investors have missed the exceptional bull market due to their fear of an imminent bear market.
• In this article, I recommend two holdings, which are likely to offer attractive returns even in the event of a bear market.

Bear markets cause traumatic experiences to investors. This is particularly true for the last bear market, in 2008, which devastated many investors, particularly those who entered their retirement phase with lack of ammunition. As a result, too many investors have remained on the sidelines and have thus missed the exceptional ongoing 8-year bull market. As it is a shame to miss a bull market due to an abstract fear of bear markets, in this article I will analyze what holdings investors can have in order to profit from the ongoing bull market while also being protected against a potential bear market.

First of all, the current bull market is the second-longest in history and most stocks have thus become overvalued or at least fully valued. Therefore, it is only natural that most investors are afraid that the next bear market may be just around the corner. Nevertheless, this fear has been prominent for years and hence many investors have missed the excellent returns that the market has offered in recent years. Moreover, while a bear market will eventually show up, no-one can predict its time of arrival. Consequently, the best approach is to remain invested to reap the excellent long-term returns of the market but only own holdings that will perform well even in the event of a bear market.

As interest rates have remained near record-low levels for almost a decade, many investors have resorted to dividend aristocrats for their reliable and growing dividend. Unfortunately, due to their attractive dividend yields, most dividend aristocrats have become markedly overvalued. To be sure, most of them are mature companies that have minimal growth rates and currently trade at P/E ratios above 20. For instance, Coca-Cola (KO), Wal-Mart (WMT), Procter & Gamble (PG) and Colgate-Palmolive (CL) certainly have these characteristics. And while these stocks clearly outperformed S&P (SPY) in the last bear market, there is no guarantee that they will outperform the index again in the next bear market, as they are poised to begin from remarkably rich valuation levels.

Surprisingly, there is a well-known dividend aristocrat that is still reasonably valued. More precisely, Johnson & Johnson (NYSE:JNJ) is currently trading at a forward P/E=17.9 while it is expected to grow its earnings per share by 8% this and next year. Therefore, it has by far the most attractive combination of growth pace and valuation in the community of dividend aristocrats. The reason for this attractive valuation is the fact that this stalwart belongs to the pharmaceutical sector, which is perceived as highly risky due to its fast-changing nature. However, Johnson & Johnson has such a consistent growth record that it does not deserve to be bundled with the other pharmaceutical companies.

On the one hand, Johnson & Johnson is facing increasing competitive pressure in its consumer segment, which generates about 1/6 of its total sales. Competition has become remarkably strong particularly in baby care, oral care and wound care. Nevertheless, this pressure did not prevent the company from growing its operating income in the segment by 1.6% in the last quarter.

On the other hand, the company has regained steam in its major segment, the pharmaceutical, which generates essentially half of its sales. More specifically, thanks to the continued strong uptake of Darzalex in US and Europe and Zytiga in Japan, the sales of the company related to oncological treatment thrive. Even better, there is ample room for future growth, as the launch of Darzalex in several countries is very recent. Therefore, Johnson & Johnson has very promising growth prospects for years to come thanks to the growth of its major segment, which enjoyed 15% growth in its operating income in the last quarter. If the above promising prospects are combined with the great consistency in the business performance of the company, it is obvious that this stalwart is exceptionally attractive under the current market conditions.

Finally, there is an even more defensive holding for the investors who are afraid that the next bear market may be just around the corner. These investors can purchase the 20-year bond of Yum Brands (YUM), which has a 6.875% coupon. When I first recommended this bond, it was trading below par so it was offering an annual yield to maturity of 7.1%. However, the bond has strongly rallied since then and hence it is now hovering around 110, thus offering an annual yield to maturity of 6.0%.

While this yield is lower than the 8.6% average historical return of S&P, it is certainly attractive under the prevailing market conditions. For instance, S&P is likely to offer a much lower return going forward from its current all-time highs. Moreover, as S&P may incur significant downside in the event of a recession, the above bond is far less risky than stocks. Therefore, given its attractive return and its low risk, the bond of Yum Brands has a much better risk/reward profile than S&P at the moment.

The reason behind the attractive yield of the bond is the fact that Moody’s downgraded the restaurant chain to junk status two years ago due to its aggressive shareholder distributions. However, the company has been growing its earnings consistently for many years while it also has ample room for future growth. Therefore, it is not likely to have any problem servicing its debt. Moreover, even if it faces unforeseen headwinds in the future, it can eliminate its share repurchases or even cut its dividend. In other words, the company has many layers of defense before its bondholders start to worry.

Moreover, its net debt currently stands at $10.4 B. While this amount is not negligible, it is only 7 times the annual earnings of the company. Therefore, if the company (hypothetically) eliminates its share repurchases and its dividend, it can pay off the full amount of debt in just 7 years. Consequently, it is not likely to have any problem paying its bondholders.

The only essential risk of the bond is that the bondholders will incur a significant opportunity cost if the average interest rates in the next two decades are far above 6%. However, given the historical data of interest rates, such an adverse scenario has very low chances of materializing. All in all, the generous coupon and the low risk of this bond render it really attractive under the current market conditions.

To sum up, too many investors have been traumatized by the last bear market and have thus missed one of the best bull markets in history. As no-one knows when the next bear market will show up, these investors can hold the above securities, which are likely to offer them excellent returns during the calm periods of the market and significantly outperform S&P in the event of a recession.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I am long YUM bonds.