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May 14 2011  / Strategy Article
Defensive Stock
Investing To Beat The Smart Money

Part 1 - Smart Money Versus Retail Investor Psyche

Part 1 - Smart Money Versus Retail Investor Psyche
Part 2 - Look To The Charts
Part 3 - Applying The Strategy To Uptrending Stocks.

 

 Defensive Stock - Definition

Most people know what makes up a defensive stock, but for those who don't know, here is a definition. A defensive stock is a stock that pays a dividend and keeps increasing their dividend despite the economic circumstances. They have stable earnings because their products are needed and in demand at all times of the year and as such economic problems do not affect them.

They are normally found in the energy sector (have to heat our homes, drive our cars, keep the lights on), food (always have to eat), drug and health care (because health never takes a holiday) and consumer staples (always need Kleenex, toilet paper, soaps)

 

Defensive Stocks - When Are They In Vogue?

Decades ago defensive stock investing was always recommended for long term buy and hold investors and "widows and orphans". This was for obvious reasons. These types of investors want security and need a stable income (widows and orphans). The strategy was sound and worked. Throughout the 20th century defensive stock investing paid the dividends many conservative investors needed and often there was capital appreciation.

That began to change in the 1980's as inflation reached lofty levels of over 10% eroding the dividends being paid by these "defensive stocks". As well there was a sudden growth of mutual fund companies who plied widely diversified and varied funds which seemed to cover every imaginable invest-able product. The next change came with the arrival of "financial planners" rather than simply brokers. These "financial planners" were suppose to be educated individuals who could take capital from investors and turn it into a nest egg for retirement.

 

The Google S&P 500 chart below shows the S&P 500 index from May 1971 to Mar 1984 often looked upon as the "hay day" of defensive stocks. From May 1971 to Mar 1984 the S&P 500 returned 51% or about 3.92% a year. Dividends paying defensive stocks obviously made a lot of sense.

This was typical of the S&P500 and a major component of the reason for defensive stock investing. The belief was always that stocks will recover and move to higher highs. However the believe was that this could take years to occur and so buying and holding defensive stocks for their dividends made a lot of sense. Midway through the 1980's though inflation reared and suddenly those dividend payments were miniscule in relation to what long term bonds and even bank certificates (Guaranteed Investment Certificates) were paying.

 

This was the catalyst that changed the concept of buy and hold for defensive stocks. Over the next 20 years, the concept of defensive investing changed from buy and hold for the dividend, to buy defensive when the market looks to be at lofty levels. This made sense as the defensive stocks supposedly would, A) survive through a market downturn and B) paid the investor to "wait" out the downturn.

 

This next chart from Google Finance shows the S&P 500 from Sep 1986 to the May 13 2011. Looking at these two charts an investor is struck by the enormous amount of volatility, spikes, market downturns, uptrends and return. It is the return that captures most investors attention. From Sep 1986 to May 2011 the S&P 500 has returned about 480% or 19.2% a year. That returns makes dividends look pretty poor.

 

The amount of wealth which the baby boom generation has accumulated is staggering and actually only a small portion of it is invested in stocks. The stock market itself pales in comparison to the amount of money in fixed income. Yet even the small amount of capital in stocks, has pushed up stock valuations and indeed increased the balance sheet of thousands of companies. Brokers, hedge fund managers, mutual fund managers and financial planners have seized upon these returns and have convinced the majority of investors that they should expect returns of 10% or greater in a year - every year. But in order to make those kinds of consistent gains, investments have to be actively managed. It is impossible to consistently make 10% a year, every year through simply buying and holding defensive stocks. Investors will jump from among mutual fund companies and ETFs monthly and quarterly based on historic returns. Many investors today invest based on historic returns in the belief that they can indeed earn 10% a year on their capital.

 

Today then, investing means chasing the latest "hot stock" or "sector" as investors tune into "Mad Money" on MSNBC and watch dozens of YouTube videos about how to invest and listen to planners talk endlessly using terms like "investment vehicle"; "commodity index"; "exchange traded funds". But by and large investors do not actually understand the various products, terms or strategies being bantered about. What they do understand is making 10% a year on their money and being upset when their financial statement arrives in the mail and shows loss of capital.

 

The whole concept of defensive investing has almost collapsed. It is paid lip service by everyone selling a financial product, but it is deeply misunderstood in today's complex investment world where the concept is to generate as large a profit as possible and get in and out of an investment quickly.

 

Understanding Smart Money and the Retail Investor

 

Smart Money is a term used to describe the hundreds of large pensions, hedge funds, mutual funds managers and large institutional investors who are considered sophisticated investors with a strong understanding of the financial markets in general and can judge or spot the latest trend in investing. They know when to get into a trade and when to get out of a trade. They are dealing in billions of dollars.

 

The Retail Investor is for want of a better phrase "the little guy" or the smaller investor who has a few thousand to a few million dollars. The retail investor is considered less knowledgeable and is usually late to any investing trend.

 

Since stock markets in general have far less capital involved than the fixed income market, stocks work in favor of smart money. This investing atmosphere serves the "smart money" managers extremely well. Historically, smart money can move into almost any sector and due to the billions of dollars involved and the float limit of stock shares for various companies, smart money can push shares up quickly and down quickly. The smart money traditionally purchases shares of stocks in sectors that they believe will have the next move up. Through their sheer buying power they carefully acquire shares, supporting share prices as they accumulate shares and then push the stock higher as they purchase the remaining shares they want to acquire. This final push up is often referred to as "window dressing".

 

By this mid to final stage the retail investor and media have become alerted to the buying by the smart money managers. It is obvous because the stock is moving higher daily. The retail investor does not have enough capital to move the shares but they can purchase them and most do in the belief that the smart money managers will keep pushing the shares higher and the retail investor believes they can sell for a profit and get out before the "other retail investor" can.

 

But the smart money managers have already made their purchases and are just doing some last minute "window dressing". This window dressing is designed to catch the attention of the retail investor as the smart money pushes the stock up a little more enticing the retail investor to purchase shares. The retail investor in almost every case will buy the shares at the top of a trend, hold these shares too long in the belief they will move higher, may even accumulate more shares as the stock pulls back in the belief that they are averaging down into just "weakness", only in the end to find out that they are holding shares for months and often years before the cycle is repeated and they have a chance to get out.

 

Defensive stocks work very well for smart money managers. First, defensive stocks are always referred to as "safe", they often have "low profit to earnings" ratios, pay a "stable dividend" and are even referred to as "attractive". Many financial planners will even tell investors that in a bear market "defensive stocks will not fall as far" as the rest of the market. This is small consolation when the market falls 40% and their defensive stock portfolio falls 25% or 30%. The incredibly sad truth about bear markets is that retail investors often sell out their defensive stock near or at the bottom, which is exactly when they should be adding to their defensive portfolio for a recovery higher. Financial planners in general do not work to ensure that clients understand the incredible risk taken with stocks and the fact that at some point in time their portfolio will fall by more than 25%. The day will come when the small investor will open their investment statement and see an enormous drop in capital as stock shares have fallen. Instead before this even occurs financial planners should advise clients that this will IN FACT HAPPEN, and they should keep some cash aside to take advantage of the fire sale prices on their "defensive stocks".

 

I am sure you have heard all these terms before. But in today's fast paced investing world, where computers reap millions of dollars with even ten or twenty cent moves, there really isn't anything "defensive" about these stocks. Instead many retail investors end up owning defensive stock which they have bought at high or over valued levels, sucked into the myth of defensive stock investing. In the end the smart money manager walks away from the stock with a very handsome profit. Looking at the chart of stocks like Johnson and Johnson below you can see how this stock has had no real capital appreciation for 10 years. Yet during this time period smart money has pushed this stock above $65.00, seven times. Every time someone ends up owning this stock above $65.00 and it is the retail investor.

When the latest hot sector, such as recently (as of May 13 2011), commodities have cooled off, analysts everywhere bring out the buzz word "defensive stock" and incredibly it is actually acted upon, by not just the small retail investor, but the so called "smart money" as well.

 

It has been smart money that has pushed up commodities and now smart money is back pushing up defensive stocks. Stocks such as PepsiCo, Johnson and Johnson, Clorox, Coca Cola are all back setting 52 week highs. The chart of JNJ above shows the dramatic move up yet again for JNJ. Incredibly as it may sound, I have a lot of investor friends who over the course of the past 10 years have bought JNJ above $65.00 on every move higher. So rather than buying the stock on the collapses, they have ended up supposedly "averaging down" by buying on the upswing always hoping they will "this time get out". Instead they end up owning even more shares than before.

 

So what can you do to not end up being the little guy stuck holding shares at lofty heights? Over 20 years ago I worked to develop a simple strategy for mapping out on charts over valuation and under valuation as well as a RETURN POINT or mid-way point on defensive stocks. That's what the rest of this article will discuss.

 

PART 2 - Beating The Smart Money - Look To The Charts

PART 3 - Applying The Strategy To Stocks In Long Term Uptrends

 

How To Invest In Defensive Stocks and Beat The Smart Money - Study The Charts

 

What should a small investor do when it comes to defensive stock investing? What can the retail investor do to beat the smart money at their own game. As anyone who frequents my site knows, I believe in staying within large cap, blue chip dividend payers. My strategy is covered here.

To understand defensive stocks you must understand that in any downturn ALL stocks will fall including the DEFENSIVE STOCKS. In bear markets every stock sinks. It is a rare bear, when certain sectors do not fall.

Let's take a look at Johnson and Johnson, one of the pre-imminent Defensive Stocks and how it fared in the various bear collapses over the past 10 years:

 

In 2000 JNJ lost 38.1%: If an investor had 10,000 in JNJ during this period and had bought at the high, it would be worth $6190.00 without taking any dividends into account.


In 2001 JNJ lost 24%: If an investor had 10,000 in JNJ during this period and had bought at the high, it would be worth $7600.00 without taking any dividends into account.


In 2002 JNJ lost 36.9%: If an investor had 10,000 in JNJ during this period and had bought at the high, it would be worth $6310.00 without taking any dividends into account.


In 2003 JNJ lost 18.6%: If an investor had 10,000 in JNJ during this period and had bought at the high, it would be worth $8140.00 without taking any dividends into account.


 In the bear market of 2008 - 2009 JNJ lost 36.4%: If an investor had 10,000 in JNJ during this period and had bought at the high, it would be worth $6360.00 without taking any dividends into account.


In between these bear market collapses, Johnson and Johnson stock also saw a variety of declines with some being as high as 11%. But then that's the nature of investing in risky assets.

 

The last chart (below) shows Johnson and Johnson over the last 10 years from 1999 to 2011. Looking back this far, gives a much clearer picture of Johnson and Johnson stock. By dividing the stock into three sections - OVER VALUED, RETURN POINT and UNDER VALUED we get an even better picture to help decide how and when to invest.

The RETURN POINT shows that in general, an investor could expect that over the course of several years, JNJ should be able to recover to around the $57.50 to $59.50 value. The over valued prices are easy to spot since the stock constantly falls back to the return point. The under valued prices are also easy to spot, again based on the return point.

 

Using Charts To Beat The Smart Money

An individual investor needs to understand that chasing stocks is in the end a losing strategy. The smart money can push stocks up and down in very short order. Getting in and out of stocks profitably that smart money is in, is difficult to do in a consistent fashion. The moves can be sudden and strong both up and down. As of writing this article, the smart money has been leaving commodities for a few weeks now, YET the analysts are just now suddenly talking up defensive stocks.

 

Look at the chart below. Since mid April the big buyers or big money have been moving out of commodities and at the same time moving into defensive stocks that just a few weeks ago were perceived as undervalued or fairly valued. But looking at the chart on JNJ it is obvous the sudden move higher. This is not just related to JNJ, but a host of defensive stocks. Yet analysts are discussing this "phenomena" like it is just happening, when in actual fact the bigger moves are already underway.

 

But it is easy to beat smart money if an investor takes the time to understand the stock and studies all of the above charts. Consider these points as you review the above charts:

1) JNJ even though a "defensive stock" will collapse just like all stocks in any bear market. Therefore as an investor, I know that Johnson and Johnson stock will fall dramatically should selling commence.

2) Looking at the charts I can see over valuation in JNJ. Right now the stock is being pushed higher. I have to ask myself if there is any point in buying the stock when the smart money is buying in and pushing it into over valued territory. The answer is simple - NO.

By answering NO, I have ended forever the retail investor's biggest problem - buying stocks too high.

3) During market contractions, I now know that I can pick a RETURN POINT. This can give me as an investor a great deal of confidence to step in and buy some shares when the stock goes into under-valued territory.

NOW I AM BUYING STOCKS UNDERVALUED! I have beaten the second worst problem of retail investors - NOT BUYING LOW.

4) I also know from the above charts that JNJ may fall further than I imagine. Therefore the best way to handle this is to buy in small lots and NOT USE UP ALL MY CAPITAL IN A PURCHASE, but to TAKE MY TIME buying stock. Forget worrying about commission rates. With today's discount brokers I can buy 100 shares at a time and average my way into the stock all the way down, because I know when it recovers that I will make such a large profit that commissions will be unimportant.

5) I know from the above charts that every collapse in JNJ has been followed by a recovery. Therefore I can buy with the confidence of knowing that at some point the stock should move back to the RETURN POINT.

6) I now know that buy and hold for this stock is probably no longer feasible unless I am content to see the stock move up and down and perhaps never actually have a decent capital gain at the end. Therefore I know that after buying the stock in UNDER VALUED territory, I will hold the stock, collect the dividend and then once it recovers above the RETURN POINT, wait for it to move into OVER VALUED territory and sell the stock.

7) I know from the above charts that there is no need to ALWAYS BE INVESTED. That if I buy the stock in the UNDER VALUED territory and sell it when it is OVER VALUED that I can get a very good return which will more than compensate me for those times when I am in cash waiting for the stock to pull back so I can buy JNJ stock in UNDER VALUED territory again.

8) I KNOW THAT THE STOCK WILL END UP IN UNDER VALUED TERRITORY SOME TIME - THEREFORE THERE IS NO REASON EVER TO CHASE THIS STOCK HIGHER.

9) By buying this stock in UNDER VALUED territory I will be selling it to the smart money, when they push it into OVER VALUED territory which is exactly OPPOSITE to what the smart money wants me to do as a small investor.

 

In the final chart below, is the past 12 months in Johnson and Johnson stock. It shows 4 opportunities during the year when an investor following the chart above which showed over valuation, under valuation and return point could  have made trades based on those valuations. A conservative approach would have returned 11.8%. However those who use stop losses could have made considerably more. In all 4 cases an investor would have been in the stock at the low and sold at the high. This shows that it is not necessary to always be invested but instead keep capital aside because opportunities will always present themselves throughout the year.

 

 

SUMMARY

This type of study is very simple to do and does not require a degree in rocket science, let alone a degree in economics.

For those not interested in buy and selling defensive stocks, the above charts are an easy way to pick option strike prices to buy and then sell or for those investors interested in selling put options, an investor could pick the appropriate strike price based on the above charts. As well, if assigned shares an investor can take great confidence that the stock will, even in a collapse, eventually move back up to the RETURN POINT, allowing the investor to consider covered calls as a strategy.

This is a straight forward approach to investing in defensive stocks and a winning approach that allows the small retail investor to beat the smart money managers at their own game..

 

 

In Part 2, I examine how to looking at charts in order to benefit from defensive stock investing and beat the smart money manager at his game.

 

DEFENSIVE STOCK STRATEGY - ARTICLE INDEX

Part 1 - Smart Money Versus Retail Investor Psyche
Part 2 - Look To The Charts
Part 3 - Applying The Strategy To Uptrending Stocks.

 

 

Disclaimer: There are considerable risks involved in all investment strategies. Trade at your own risk.
Stocks, options and investing are risky and can result in considerable losses. None of the strategies, stocks or information discussed or presented are financial advice, trading advice or recommendations. Fullyinformed.com is a private website. Everything presented and discussed are the author's ideas and opinions only.
By using this site, you agree to be bound by its terms of use. The full terms of use can be read here. If you do not agree to the terms of use, do not use this site. The author of fullyinformed.com assumes no liability for topics and ideas discussed, errors and omissions, ads and their content and external links. Any corporate insignia used are registered trademarks of their respective company or corporation and are being used for identification purposes only. All material copyrighted by FullyInformed.com. Reproduction in whole or in part prohibited. Copyright 2008

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