The Flight to Safety Could Burn You

Although the S&P 500 is up a whopping 2% year to date, it's still down more than 40% since its high in October 2007. Investment banks are no more, housing prices continue to drop, unemployment keeps rising, and we're in a recession, with no clear uptick in sight.

Until recently, investors have abandoned the market in droves. Stock mutual funds saw net cash outflows of $33 billion in 2008. Although April saw net inflows of $12 billion, year to date stock mutual funds have still lost $30 billion in redemptions.

If there were ever a time for a defensive play, you'd think this would be it. And in fact, a lot of ink has been spilled this year touting the virtues of classic defensive plays such as Eli Lilly (NYSE: LLY  ) , PepsiCo (NYSE: PEP  ) , Merck (NYSE: MRK  ) and General Mills (NYSE: GIS  ) .

After all, the story goes, even when times are tough, people will still eat, they'll still heat their homes, and they'll still buy their medicines.

But if you've been putting your money in blue-chip consumer staples, pharmaceuticals, and utilities on the theory that it will be relatively safe there, you may want to think again.

First, it's not working
While defensive plays may have worked in previous downturns, they aren't working in this one. The collapse of the financial markets only intensified the existing economic strains on the American family.

Even though the market has been experiencing a rally, "defensive" stocks haven't necessarily followed suit. Drug manufacturers are down 6% year to date, food manufacturing is down 3%, and grocery stocks are down 6%. Even utilities aren't escaping: Electric utilities are down 11%, and water utilities are down 10%.

And that underperformance applies to well-known individual stocks in those sectors as well. Merck is down 8% year to date, Kraft (NYSE: KFT  ) is down 2%, Campbell's Soup Company (NYSE: CPB  ) is down 7%, and Procter & Gamble (NYSE: PG  ) is down a whopping 15%.

It turns out that when things get bad enough -- and a collapsed housing market, recession, a collapsing auto industry, and a shaky financial sector count as "bad enough" -- people do cut back on even the essentials.

In other words, a defensive play really isn't going to save your portfolio right now.

Second, it's a bad strategy
But even when macroeconomic factors don't conspire against the defensive play, it's still not a good strategy for your money.

Essentially, a defensive play is a "next hot sector" play -- only when times are tough, investors are content to find the "next not-as-bad sector" instead of the next hot one. But just as chasing hot performance will likely leave you empty-handed, investing in defensive plays when times are tough just because they're defensive plays will undermine your long-term returns. Why?

  1. It's historical, not forward-looking. The "next hot sector" is only apparent after it's warmed up -- and that means it's likely to cool down. Just ask anyone who was invested in tech stocks in early 2000 -- just because it was hot doesn't mean it was sustainable. And just because so-called defensive stocks are in historically stable industries doesn't mean the companies or the industry in question won't be rocked by events no one saw coming. Remember, up until this year, financials were believed to be defensive stocks, too.
  2. It doesn't focus on the company. Even assuming an industry holds up against downward market pressure, it doesn't mean an individual company will come out smelling like a rose -- and just because a sector takes a nosedive doesn't mean a company will. Adobe Systems, for example, has returned 12% annually over the past 10 years -- bypassing the tech bust entirely.

The Foolish bottom line
So if you want to stay in stocks (and if you have money you don't need for the next five years, you should), where you should invest? Rather than trying to find stocks that won't lose very much in the turmoil, you should be looking for companies with excellent management, strong competitive advantages, excellent prospects, and strong balance sheets -- because those will outperform over time, even if the near-term still looks stormy. Buying and holding is still the best choice for the majority of your portfolio -- especially when so many stocks are trading at unbelievable lows.

That's what we're doing at Motley Fool Pro, our new investing service -- but that's not all we're doing. Fool co-founder David Gardner and his Motley Fool Pro team are investing $1 million in a portfolio designed to make money in any market.

The team, relying heavily on proprietary CAPS "community intelligence" data, is establishing long and short positions in a broad range of securities, including common stocks, publicly traded put and call options, and exchange-traded funds (ETFs). To learn more about Motley Fool Pro and to receive a private invitation to join, simply enter your email address in the box below.

This article was originally published on Oct. 8, 2008. It has been updated.

At the time of publication, Julie Clarenbach had no stake in any company mentioned in this article. Procter & Gamble and PepsiCo are Income Investor choices, and Kraft is a former one. The Motley Fool owns shares of Procter & Gamble. The Motley Fool's disclosure policy plays offense, not defense.


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