Defense Is the Best Offense

This is a tough time to be an investor. Sure, the market has rallied lately. But we could very well be witnessing just a bear-market rally. Nobody knows if the Dow will hit 10,000 before it hits 14,000.

Why not stay away?
The thing is, we still need to grow our savings. Hiding on the sidelines of the market for several years can seriously set back our long-term returns. Six-month CDs aren’t even paying 3.5% in most cases, and most money markets are under 3%. In addition, by staying on the sidelines, we risk missing a huge market upswing when the market turns around. Typically, an investor who is out of the market gets back in only after learning from osmosis that things have gotten better. By that time, chances are that investor will have missed a significant market upswing -- and missing big market upswings can kill your long-term performance.

For example, from Dec. 31, 1994, to Dec. 31, 2004, the S&P 500 returned 12.07% annually. Without just the 10 best-performing days in that period, the return falls dramatically to 6.89%.

The market has always been a long-term winner. But no one ever knows when the market will turn; it seems to surprise us every time. Although no one can tell whether the next 10% move in the market will be up or down, everyone knows the direction of the next 100% move.

What kind of stocks to look for
What we need are stocks that will hold their own if the market tanks and take off if the market goes up. Do such investments exist? Can we have our cake and eat it too?

There are several basic defensive properties investors can look for to answer this question. One important defensive characteristic is a low beta. Beta is a measure of a stock’s volatility in relation to the overall market. A beta of less than 1 means that a stock moves less than the market. This is a nice quality to have when the market goes down.

Motley Fool CAPS is a great place to screen for stocks of companies with the aforementioned characteristics. The universe of stocks rated with five stars (the highest possible) by the 115,000-member CAPS community has handily beaten the market. Searching the five-star universe for stocks with good defensive and offensive characteristics can produce some worthy candidates for today’s market.

I searched for five-star-rated stocks with the following criteria:

• Price-to-earnings ratio of less than 10 (selling fairly cheap)
• Beta of less than 1 (defensive)
• Debt-to-equity ratio of less than 1 (strong financial condition)
• EPS growth of more than 20% for the last three years (growing business)
• Return on equity of at least 20% (efficiently managed)

Keep in mind that these stocks are not recommendations, merely suggestions to invite further research.

A stock worth mentioning that didn’t make the chart is Kinetic Concepts (NYSE:KCI). The medical technology company had a price-to-earnings ratio above 10, but it is still a reasonably valued company in a defensive industry.

Some markets are tricky. We need to play offense with an eye toward defense. Stocks that hold up during down markets keep us in the market while allowing us to participate in the upswing.

Staying involved in the market and maintaining the value of our portfolios can poise us to benefit from market turns that other investors aren’t around to enjoy. What we do as investors during bad markets can separate us from the pack.

For more research on these companies, see what 115,000 investors have to say on our free CAPS site.