Late in the business cycle, the road to riches usually isn't straight and smooth. I spent most of my time in 2018 warning investors about the dangers of buying cyclical stocks near their highs and trying to find alternative investments that were more defensive in nature. The idea behind a defensive investment is one that will produce better returns than cash when the market goes up, but fall less than the market in the event of a bear market. While this sort of investment could be useful for many types of strategies late in the business cycle, I specifically sought out defensive investments in 2018 for two reasons.
The first reason was that I wanted to use these investments as part of a larger rotational strategy as a place for investors who sold cyclical stocks to put their money until the prices of the cyclical stocks came down. The second reason was a psychological one. Since in early 2018 I found myself writing bearish article after bearish article, I wanted to guard against becoming a 'perma-bear' where whenever I looked at anything all I saw and focused on was the downside. Because of this fear, I set a goal for myself to find at least one long idea each month while I was writing all these bearish articles so that I would force my brain to work and think in both directions. (These individual defensive stocks were in addition to the standard ETF defensive alternatives that I included in almost all of my bearish warning articles.)
These individual defensive ideas, including a few that I wrote about in conjunction with my warning articles, were: Johnson & Johnson (JNJ), Berkshire Hathaway (BRK.A) (BRK.B), Hawkins (HWKN), MolsonCoors (TAP), British American Tobacco (BTI), Fiserv (FISV), and ABM Industries (ABM). The results, so far, have been mixed, but probably better than average. Combined with what I have learned from tracking my defensive ETF ideas through the 2018 correction, I've gotten a better grasp on what worked and what didn't. My main takeaway so far has been that if one is getting defensive with the intention of using a rotational strategy, ETFs are a better way to do that than individual stocks because the ETF price movements tend to be slower and more predictable than any individual stock. And since the rotational strategy relies on the defensive position doing relatively well at the same time the target stock sells off, it's best to have the diversification of the ETF so that it is unlikely to have a massive sell-off at the same time as the target stock.
With that said, not everyone is using a rotational strategy. Some investors might just want to be fully invested at all times and when new money comes into their account, they might want to find some individual stock ideas even when the market is high. My hope is that I offer a few things to think about in terms of what to aim for when the market is late in the business cycle, but you still have money you would like to invest.
Examining These Ideas
This obviously isn't a scientific or statistically significant sample of stock ideas, but there are a couple of things I was looking for when it came to these defensive ideas. The key factors were that I wanted stocks that were trading well off their highs and also running what I considered to be defensive businesses. And/or I wanted stocks that had a history of falling less than the market during previous downturns. Johnson & Johnson (JNJ) I suggested as an alternative to 3M (MMM) because I thought investors who liked 3M would probably also consider J&J a reasonable investment as well. JNJ did its job, and investors who rotated into it eventually had an opportunity to rotate back into 3M at a much lower price, but even though the idea was a success, we saw from the unexpected baby powder litigation with JNJ that there was a stock-specific risk associated with JNJ that made it ill-suited as a defensive investment from a rotational perspective.
That said, when the litigation wasn't being focused on by the market, JNJ held up well during the correction, even compared to the S&P 500, so, if this single issue with the baby powder hadn't been going on, I think it would have held up very well as a defensive position, just as it had done over past cycles.
Similarly, Berkshire Hathaway held up well during the correction as well. So, stable businesses that have lots of cash and diversified income streams will probably do well in relatively well in bear markets (and Berkshire is still a good defensive position if you are forced to put money to work today).
Two ideas that didn't work as well as defensive investments from the time I wrote about them through the correction were TAP and BTI.
I made a second BTI investment after the price dropped:
The main factor that made these two investments more difficult as defensive investments were that they had both recently made big acquisitions and carried a lot of debt because of those acquisitions. So, even though they were trading well off their highs and were both in what I consider to be defensive and recession-resistant industries, it was hard to know just where the bottom might be for the stocks. I still hold both of them, but neither proved to be particularly defensive during the correction. For this reason, if I was selecting an individual stock in the future as a defensive position, I would probably avoid stocks that had recently made big acquisitions and/or carry substantial debt loads. That doesn't mean these investments won't eventually work out, it just means that I can't count on them to fall any less than the S&P 500 during a downturn.
On the flip-side of this, I did have one idea, Hawkins, who made an acquisition in 2015 it was working through, that did provide a +25% return for me in 2018. The key with this one, though, is that they had far less of a debt load than TAP or BTI, and the benefits of the acquisition were just beginning to take hold three years after the acquisition. Still, there was no guarantee that that would happen before the correction, so, while I think I would have done okay with Hawkins no matter what, I would still avoid buying stocks for defensive purposes that recently made a big acquisition that required taking on lots of debt.
One other type of defensive stock one might take a chance on late in a market is one with steady earnings growth even if it is slightly overvalued. That was the case with Fiserv when I suggested it back in 2018 as part of a defensive alternative to American Express (AXP).
It held up very well leading up to and during the correction. Now, of course, they have announced a big acquisition, so it's probably time to take profits here (this one I didn't buy myself because I thought it was a bit expensive), but it proved to be a reasonable strategy in this case. So, for Fiserv, the key was incredibly steady secular growth that held the potential to achieve good upside before the next bear market and to maintain good earnings throughout a bear market. Fiserv has been more of a growth story than typical 'defense' investments, but growth supported by steadily rising earnings can still work, even if it's not my typical style of investing. If I was a growth investor, this is the type of stock with which I would look to play defense late in the business cycle.
Finally, we get to the 2018 defensive stock that I most wanted to highlight today, ABM Industries. Here is how it has performed since my article "ABM Industries: A Good Late-Cycle Buy" on June 21st, 2018.
Since that article, there was really only one week in mid-December that the stock briefly underperformed the S&P 500, and it immediately bounced back, and then some. Here is what I had to say about it in my original article:
The potential for a breakout that we've recently seen with Hawkins stock is the sort of reward I'm aiming for with these sorts of defensive investments late in the economic cycle. In short, I want a defensive business, a fair price, and a recently established market price that is much higher than what the stock is trading at today. And I believe we get all three of those with ABM Industries...
At the time of that writing, ABM was trading -30% off its highs, which was much farther than it had traded off its highs historically, except during market downturns. In the end, I concluded:
Since ABM is only trading slightly below its long-term average multiple and has debt levels that are bit higher than normal, I am assigning it a portfolio weighting of 1% and have purchased the stock in between $30 and $31 per share. I will reserve an addition 1% for one more purchase if the stock price falls to $20 per share (which will probably only happen in the event of a bear market). Since we are likely in the later stages of a bull market, I'll be looking to take profits after a 25-30% gain, or a share price around $39, if the bull market continues for another year or two and ABM stock price rallies.
So, the goal with this investment was to see if we could secure a 25-30% total return before the next bear market, and if the bear market came before then, to not experience a drawdown deeper than the S&P 500. That's pretty much the definition of a good risk/reward over the medium-term. The risk was market-neutral returns and the reward was a 25-30% gain. And, that's essentially what we saw play out during the correction and recovery. During the correction, ABM fell about the same as the market, but since the bull market wasn't over yet, ABM bounced back quickly and produced great gains. With the goal now achieved, I'm taking profits.
What I think worked well for both Hawkins and AMB, was that they weren't large-cap stocks, they were both trading well off their highs, they were in relatively boring industries, and their debt wasn't really high. Perhaps the aspect I want to focus on most here is that they weren't large-caps. For whatever reasons investors love their large-cap stocks. My experience has been that I could write about 10 small-and-midcap winners like Hawkins and ABM, with solid 25-30% gains in less than a year, and 9 out of 10 readers will be more interested in a widely known, but far less valuable on a per share basis, large-cap (especially if the large-cap pays a decent dividend). This dynamic at least partially contributed to my decision to reserve all of my future small-and-midcap ideas for members of the Cyclical Investors Club because the small-and-midcap ideas are more likely to be appreciated by members of the Club than they are by the general public, which has a tendency to shrug off even some of the best ideas simply because the company isn't perceived to be big enough to provide value.
The irony that risky large-caps attract the most attention is worth capitalizing on as investors. When I can, I always try to offer alternative investment ideas if I'm selling a stock or suggesting other investors would be better off selling a stock. In this case, I think we should continue to stay defensive because we are still late in the business cycle, but diversify our risk while at the same time avoiding the mostly overvalued large-cap universe of stocks. So I have moved my proceeds from by 2019 realized winners (Cummins (CMI) +20%, Tiffany (TIF) +25%, and Emerson Electric (EMR) +22%) to Invesco S&P MidCap Low Volatility ETF (XMLV). This is a similar ETF to SPLV, which has been my 'go-to' defensive alternative for much of 2018, except that XMLV invests in mid-cap stocks instead of large-caps, thereby avoiding some of the risk associated with overbought large-caps at the moment.
Over the past year-and-a-half, I've experimented with several slightly different approaches for what sort of equities to buy during the late stages of the business cycle. Here are some of my initial findings. Low-volatility ETFs like SPLV and XMLV are good all-around choices, and they adjust quarterly so they don't need to be monitored particularly closely in terms of their valuations. If one combines a low-volatility ETF with a sector ETF that has had a significant negative divergence from its relative performance and is also defensive in nature (for much of 2018 Vanguard Utilities ETF (VPU) fit this description) that can help with returns while staying defensive as well.
Moving to individual stocks, for value investors there might be a few small-and-midcap opportunities for boring businesses that have experienced recent sell-offs of -30% or more, that aren't carrying a high debt load like Hawkins and ABM. These sorts of stocks can potentially provide limited downside, but solid upside late in the cycle.
For growth investors, focusing on businesses that grew earnings during the previous recession and have had steady earnings growth throughout the cycle that trade at reasonable P/E multiples, of say, 25 or less, might have limited downside compared to the outsized gains they could potentially achieve before a downturn like Fiserv. I would make sure to focus on stocks whose earnings are recession resistant, and not too expensive though.
The jury is still out on those stocks whose businesses are defensive, but who have taken on debt for large acquisitions. It is possible that they could recover before, or even during, a recession, but it's hard to know what price to buy them as they are falling, so I would ease into these a little at a time if I decided to buy them. My second purchase of BTI is doing well, but the first one hasn't been.
With the sale of ABM, since I started writing for SA in 2015, out of 28 total realized ideas (ideas in which I first shared a 'buy' idea, followed by a 'sell' update) 25 have been profitable and 3 have been unprofitable. 21 of the ideas outperformed their benchmark and 7 underperformed.
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Disclosure: I am/we are long brk.b, bTI, XMLV. 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.