Seeking Alpha

5 U.S. Defensive Stocks Earning Top Quality Scores

|
Includes: BIIB, CHD, CHE, IDXX, ROL, SPY
by: Steven Chen
Summary

Exposure in defensive businesses does not necessarily mean sacrificing upside potential.

Intelligent investors who look to hedge against an economic meltdown should consider high-quality defensive stocks.

Here are my five picks out of the top-ranked names per my Quality Score model.

Source: kalkinemedia.com.

Overview

No one can accurately predict the market. But those who would like to "hedge" against the possible upcoming economic hardships could take a look at recession-proof stocks, and accumulate shares at the right price over time.

One point worth mentioning is that increasing exposure in defensive stocks does not necessarily mean giving up upside potential. On the contrary, playing defense appropriately can often be the best "offense" (to generate long-term alpha). One example is to invest in predictable businesses. In this regard, investors may want to start with high-quality businesses.

Here, I would like to examine the latest stock ranking per my Urbem Quality Score model and pick my five favorite U.S. defensive stocks among the top companies.

Quality Score

Again, for those who are not familiar with the Urbem Quality Score, the system is simply a quantitative model ranking businesses mainly based on the following fundamental factors:

  • Returns on capital and their consistency
  • Capex requirement to sustain year-to-year operations
  • Cash flow
  • Balance sheet
  • Growth health

For the 50 U.S. stocks earning the highest Quality Scores, I went through their stock and, more importantly, business performances during the last recession (between 2007 and 2009). In particular, I am looking for businesses that managed to grow and deliver high ROICs even in a tough time.

Below list my five picks of U.S. defensive high-quality stocks. As usual, when it comes to building a recommendation list, valuation is not the primary consideration, meaning that this is not a buy-right-now list. However, I believe that each stock is worth a good seat on the close watch list for those seeking protection from market downturns. Stock prices just go up and down over time. Long-term investors just need to patiently wait for attractive entry points that Mr. Market happens to offer. In my view, figuring out the attractiveness of valuation is far easier than being patient. As the saying goes, "investors are their own worst enemy."

Biogen (BIIB)

Biogen focuses on the discovery, development, and delivery of worldwide innovative therapies for people living with serious neurological and neurodegenerative diseases, which is now the No. 1 cause of disabilities and No. 2 cause of deaths globally.

Patients need to be treated no matter how the economy is going, which makes the healthcare sector a recession-proof one. As described below, the business at Biogen managed to grow its top line while improving the annual return on tangible assets throughout the last recession.

Source: GuruFocus; data as of 8/10/2019.

Source: GuruFocus; data as of 8/10/2019.

From a price multiple perspective, the stock looks cheap at the moment. For example, it yields free cash flow at almost 14%, hitting a multi-year high (see below). This was largely thanks to the plunge following the company's termination of two late-stage studies of Alzheimer's candidate aducanumab due to lack of efficacy.

While short-term growth could be impacted, long-term investors may find now to be an interesting but rare entry point for this stock.

Source: GuruFocus; data as of 8/10/2019.

IDEXX Laboratories (IDXX

)

IDEXX develops, manufactures, and distributes products and provides services primarily for the companion animal veterinary (e.g., in-clinic diagnostic solutions, outside reference laboratory services), livestock and poultry, dairy and water testing markets.

The company has been enjoying quite some secular growth in the pet industry. One interesting point worth noting about the industry is that, according to some studies, people are more likely to cut spending for themselves or even their children than for pets. This is exactly what IDEXX needs to protect its business from an economic decline.

During the Great Recession, the business was able to grow its sales and to maintain its return on tangible assets at a superior level (i.e., above 20%), as displayed below.

Source: GuruFocus; data as of 8/10/2019.

Source: GuruFocus; data as of 8/10/2019.

When it comes to valuation, the stock may look a lot less interesting to many investors, including me. The P/FCF is near the multi-year high, so I would wait for a significant pullback before acting on IDXX.

Source: GuruFocus; data as of 8/10/2019.

Rollins (ROL)

Rollins is the world's largest pest/termite control company, which has a stellar financial track record of increasing its both top line and bottom line every year for 20 years, spanning several economic slowdowns.

The company has proven itself to be a truly recession-proof business. The secret? Regardless of macroeconomic trends, you always need someone to kill the cockroaches, termites, bed bugs and so forth. For residential customers, termites can seriously devalue their properties and tolerance for bug bugs overnights should always stay minimal; for clients in the food and beverage/ hospitality industries, a pest-free environment minimizes the risks of customer complaints and even food contamination.

Over the last recession, Rollins did not experience any deceleration of its business growth (see below). Even better, it even improved its annual return on tangible assets throughout the tough period (at least for many other businesses).

Source: GuruFocus; data as of 8/10/2019.

Source: GuruFocus; data as of 8/10/2019.

The stock experienced some pullbacks this year and as a result, the free cash flow yield has been getting more reasonable, being around 2.5% at the moment. However, for those who demand more margin of safety, the current valuation should be still high.

Source: GuruFocus; data as of 8/10/2019.

Chemed (CHE)

Chemed Corporation operates two wholly-owned subsidiaries: VITAS Healthcare, the nation's largest provider of end-of-life hospice care, and Roto-Rooter, the nation's leading provider of plumbing, drain cleaning, and water cleanup services.

It is hard to think of the commonality between the two businesses here, except that both are recession-proof in nature. You need plumbing whenever you have to need it, despite the financial condition, and at VITAS, approximately 75% of the consolidated net accounts receivable due come from Medicare, Medicaid, and Managed Medicaid.

Chemed managed to both increase its annual revenue per share and improve its annual return on tangible assets, as shown below.

Source: GuruFocus; data as of 8/10/2019.

Source: GuruFocus; data as of 8/10/2019.

The current valuation on the share does not look so interesting with a 33x P/FCF (see below). The ratio stayed below 20x roughly half of the time over the past 15 years or so, and dropping below that 20x line could be my trigger point to act on the stock.

Source: GuruFocus; data as of 8/10/2019.

Chemed and Rollins are also two of the four stocks on my "Boring Stories but Powerful Returns" list.

Church & Dwight (CHD)

Church & Dwight develops, manufactures, and markets household, personal care, and specialty products under multiple brands in multiple categories.

Some of the company's market-leading products include the No. 1 baking soda, the No. 1 condom, the No. 1 pregnancy kit, the No. 1 oral care pain relief, and the No. 1 many more... As you may already have imagined, it would rare for consumers to cut spending on those products even during economic hardship.

The company handsomely grew its business just as usual with the improvement in annual return on tangible assets during the 08/09 financial crisis (see below).

Source: GuruFocus; data as of 8/10/2019.

Source: GuruFocus; data as of 8/10/2019.

The stock is currently priced at a 26.6x P/FCF, which looks a bit high compared to its historical (see below). A 5% free cash flow yield or a 20x P/FCF may make me more comfortable to establish a position in CHD.

Source: GuruFocus; data as of 8/10/2019.

Summary

As you see above, all of the picks grew their revenue with superior ROIC during the last recession. It is out of the question that their stock performances should reflect the fundamentals. As shown below, all stocks managed to beat the S&P 500 (SPY) from 2007 to 2009, delivering alpha for their investors.

Source: Yahoo Finance.

I hope that you enjoyed my list above. What is your favorite high-quality defensive stock at the moment? Feel free to comment below.

Disclosure: I am/we are long ROL. 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.

Additional disclosure: Mentioning of any stock in the article does not constitute investment recommendations. Investors should always conduct careful analysis themselves and/or consult with their investment advisors before acting in the stock market.