3 Stocks for the Ultimate Defensive Portfolio

Every investor is mainly concerned with one thing: protecting his or her portfolio.

Right now, one of the biggest problems facing investors is where to find this protection. Traditionally, investors would look to the bond market for protection. However, some analysts now consider bonds overvalued and due for a correction if the Federal Reserve slows its asset purchase program.

With that in mind, I have snuffed out three companies that would provide a great defensive backbone for any investor's portfolio.

I used three key criteria to whittle down the eligible companies:

  1. Demand: The company must offer a product or service that is likely going to experience continual demand regardless of the economic situation.
  2. Past performance: The company must have a history of investor returns, including but not limited to share buybacks and a good dividend record. 
  3. Financials: The company must have a balance sheet with little debt and plenty of cash to cover short-term liabilities.
I did find though, that few companies match these criteria exactly, so I may bend the rules slightly. That said, my picks are still in highly defensive industries.

The contenders
Contender No. 1 is evolving into a good-looking defensive company. That said, the company has not completely evolved just yet; meaning there is still some risk. Energizer Holdings (NYSE: ENR  ) used to be known for its batteries, but they are now only a tiny part of the company's operations. In fact, alkaline battery sales only accounted for 29% of the company's overall sales during its fiscal first half. By comparison, 35% of the company's sales were related to wet shaving products, and 9% were for skin care, which are two extremely defensive markets.

Energizer has a net profit margin of around $0.10 on every $1 of sales, which makes the company highly cash-generative. Moreover, Energizer's management are looking to return this cash to investors through dividends and stock repurchases. The company repurchased 3.3 million shares from the second quarter of fiscal 2012 to Q2 2013 -- this was around 5% of the company's issued share capital.

Although the company's investor returns are currently impressive, Energizer has only paid a dividend for the past two years, and the buyback is a one-off. Still, the company is transforming itself into an extremely defensive entity, and the company's balance sheet is clean, with total debt of $2.4 billion at the end of the second quarter, representing about 35% of assets. Therefore I'm willing to grant this stock some leeway.

The world's most defensive market
Contender No. 2 is a company within one of the most defensive sectors in the world: death care. It is often said that there are only two certainties in life: death and taxes. According to the National Funeral Directors Association, the number of deaths per 1,000 people is expected to rise from the rate of eight per year in 2011 (the most recent available data) to 8.4 by 2020, 8.9 by 2030, and nearly 10 by 2045. This is a compound annual growth rate of about 2.9%.

Service Corporation International (NYSE: SCI  ) is extremely well-placed to benefit from this trend. What's more, the death care industry remains highly fragmented within the U.S., as about 86% of the funeral homes within the U.S. are privately owned. Furthermore, Services' recent acquisition of Stewart Enterprises, the second-largest death-care company in the U.S., will create a national giant that has good economies of scale in one of the world's most defensive industries.

At the end of the second quarter, Service had a clean balance sheet with a net-debt-to-asset ratio of 18%. The acquisition of Stewart will add an additional $1.4 billion in debt, however. That said, I estimate that this extra debt will take the net-debt-to-asset ratio to 34%, which is still manageable. 

Service Corp. has paid a dividend since the beginning of 2005. The quarterly payout started at only $0.025 per share but has since grown to $0.07 per share. That's 180% growth over eight years. If this continues, the payout will hit $0.20 per quarter by 2021.

A dividend play
For the No. 3 contender, I have picked American States Water (NYSE: AWR  ) , a company with one of the longest dividend histories going.

American States Water has paid a dividend to investors every year since 1931 and has increased this payout every year since 1954, which is longer than almost any other company. The company recently hiked its dividend payout by 14.1% -- more than what was expected for a utility company, as utility payout increases usually follow inflation.

American States provides water, electricity, and related services to about 256,000 customers throughout 10 counties in northern, coastal, and southern California. Of course, any utility company is defensive, but few companies come with a payout history as rich as that of American States. Utility companies are generally considered good defensive backbones for any portfolio, but American States is more defensive than most. The company's debt is low at 26% of assets, and its cumulative dividend payout of $13.7 million was more than covered by its operating cash flow of $33.6 million for the period.

Foolish summary
These three companies are all highly defensive and could form a great defensive backbone to any portfolio. That said, they may not suit everyone.

Still, the thesis I have used to select them is a good method of searching for your own defensive stocks that will help ensure your portfolio stays healthy through periods of market turbulence.


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