Stocks Good stocks for tough times

In the year just begun, investors face economic headwinds in nearly every corner of the globe. All eyes are currently focused on the euro zone, where austerity measures are being redoubled to combat crushing debt loads. Compared to Europe, the US economic outlook looks less dim, although benefits from past fiscal and monetary stimuli have mostly run their course.

Even in emerging markets, which have acted as catalysts for growth worldwide, challenges from slowdown and inflation are posing new challenges. 

But despite these unfavourable economic prospects, now is not the time to trade out of equities. Indeed, a century of stock market return data argues for staying invested, for the long term, rather than trying to time markets.  

The best investment strategy is to own a portfolio proven to generate favourable returns in even the toughest economic environments. As such, portfolios should be built around defensive industries, particularly those offering strong cash flows and dividends, while having some exposure to smaller stocks.  

Stocks of companies that sell necessities, where profits are largely insensitive to economic swings, rarely go out of favour. Because people must eat, products from food makers, like Danone (BN FP) and Pepsi (PEP), along with food retailers Sainsbury (SBRY LN) and Wal-Mart (WMT), are in constant demand.  

US stock market data from 1926 through 2009 indicate that returns from dividends, at slightly more than 4 per cent a year, only narrowly trailed gains resulting from capital appreciation, at less than 5.5 per cent, according to Morningstar/Ibbotson. Moreover, since December 1999 the S&P 500 index had lost 17 per cent in value through mid-December 2011, yet returned around 2 per cent per year to investors via dividends during this period. 

As with food companies, health care companies fill basic needs – especially as the population of wealthy countries age – throwing off plenty of cash. Prescription drug makers, like Eli Lilly (LLY) and Novartis (NOVN), can help maintain our health and improve our wealth – thanks in part to dividend yields in excess of 4 per cent.  

Of all industries, tobacco has offered perhaps the best income and growth investments during the past two economic cycles, dating from 2002. Thanks to operating profit margins of 30 to 40 per cent and modest new capital investment needs, British American Tobacco (BATS LN) and Philip Morris International (PM), are able to return huge cash flows to shareholders in the form of buybacks and dividends – at around 4 per cent. 

Among the most impressive dividend-paying industries is Real Estate Investment Trusts (REITs). Tax laws, while limiting their ability to grow and confining their activities to passive ownership – rather than operations – allow REITs to avoid income taxes to distribute virtually all of their operating profits via dividends. 

There are numerous types of REITs from which to choose, ranging from traditional property REITs (eg industrial, office etc), such as Duke REIT (DRE), to mortgage REITs, like Analy Capital (NLY). DRE has about a 5.9 per cent dividend payout and NLY yields an impressive 14.7 per cent.  

Although stocks of large, well-established, brand name companies should account for the majority of any conservative equity portfolio, small caps also have a place, as they provide solid growth and surprising resilience through the most difficult economic environments. 

Since the early 1990s, Japan’s economy has been among the worst performing in the developed world. Despite that, over the past 10 years to December 2011 the Topix Small Cap Index returned almost 23 per cent overall. Though this annualised return of 2 per cent might seem modest, the gains are very impressive when compared to its large cap counterpart (Topix Core 30), whose losses totaled about 46 per cent from December 2001.  

During this same period in the US, small stocks, as measured by the Russell 2000 Index, also handily beat large companies, generating better than 6 per cent annual returns or twice that of the large cap S&P 500 Index. Moreover, in this 10 year span that included two recessions, small outperformed large in the bear markets that ended in 2003 and 2009. 

To gain broad exposure to small cap stocks, an ETF is the simplest and most cost-effective route for individual investors. IWM or EWRS serve these objectives equally well.  

With global economies likely to slow before they improve, a cautious approach is warranted, at least through 2012. By being defensive, focusing on cash flows and income, and thinking small (cap), investment portfolios should stand tall through a challenging 2012 and beyond.  

William Mack

William Mack