When markets get crazy -- Brexit, anyone? -- many investors begin looking for safer, non-cyclical stocks with sustainable business models and growing dividends. That's the idea of defensive stocks: They're there to anchor a portfolio with less volatile holdings so that risk-averse investors and income investors can grow their wealth without the stress of wild market gyrations.
Image source: Getty Images
Here are five top defensive stocks for 2016.
| Stock and Ticker | Market Capitalization | Dividend Yield | Cash Dividend Payout Ratio |
| Johnson & Johnson (JNJ 0.80%) | $325 billion | 2.8% | 56.8% |
| CVS Health (CVS 1.54%) | $101 billion | 1.8% | 26.2% |
| Realty Income Group (O 1.63%) | $18 billion | 3.6% | 83%* |
| Procter & Gamble (PG -0.22%) | $220 billion | 3.3% | 62.2% |
| Coca-Cola (KO 1.27%) | $191 billion | 3.2% | 83.1% |
Source: S&P Market Intelligence. *Since Realty Income Group is a REIT, I believe that the dividend as a percentage of Adjusted Funds from Operations, or AFFO, is a better marker, and so I have displayed that number instead of the cash dividend payout ratio.
These stocks have three major things in common.
Big, stable dividend stocks
As the chart above shows, the smallest stock in this group by a long shot is Realty Income Group, at a roughly $17 billion market cap. That's not small by any means -- but it's dwarfed by the largest, Johnson & Johnson, at over $300 billion. All of the others are $100 billion or higher.
All have dividends that are well-covered by free cash flow, as evidenced by dividend payout ratios under 85%, which you can see in the chart above. In fact, three -- Coca-Cola, Procter & Gamble, and Johnson & Johnson -- have been designated "Dividend Aristocrats," or stocks that have paid dividends that increased at least once annually for at least 25 years straight. (In Realty Income Group's defense -- the company hasn't been publicly traded long enough to win the designation, and has increased the dividend 85 times since 1994.)
These are companies that are likely to be around for a very, very long time. And keep paying growing dividends while they're at it.
Consumer focus, but with some diversification
All five of these stocks have at least a partial focus on consumer goods (think of them as part of a broad consumer defensive sector). Realty Income Group, which is a real estate investment trust (or REIT), purchases buildings which it leases out -- primarily freestanding retail buildings that are then rented to gyms, fast-food restaurants, pharmacies, and the like. Coca-Cola and Procter & Gamble in many ways define powerful branding. Coca-Cola, of course, has been leading fantastic branding campaigns around Coke and Diet Coke for years, and its non-soda brands -- including Dasani, Minute Maid, and Vitamin Water -- are also household names. Procter & Gamble the company isn't as well-known, but its cleaning and grooming supplies are ubiquitous, including household names such as Gillette, Clorox, Charmin, Bounty, Pampers, and Tide.
Johnson & Johnson is well-known for its baby shampoo and the pain medication Tylenol, although over 80% of its sales now come from its lesser-known pharma and medical device divisions. CVS is best known for its pharmacies, although it actually gets most of its revenue from its lesser-known pharmacy benefits management business.
It's great that each of these stocks is in tune with the average American shopper...and even better that they're more broadly diversified. With this portfolio of five stocks, an investor gets two major healthcare companies in Johnson & Johnson and CVS, two huge consumer brand pure-plays in Procter & Gamble and Coca-Cola, and a big real estate operator in Realty Income Group.
Even defensive stocks have incoming threats
Each of these companies faces threats of one form or another. Coca-Cola's growth could be hampered by the move toward calorie control; for P&G, upstarts like Dollar Shave Club threaten to take market share. The healthcare companies are both threatened by consolidation across the sector, and J&J in particular could see its drugs attacked as patents expire and its core drugs face increasing competition from new therapies (as happened recently with its Hepatitis C drug Olysio). For Realty Income Group (and REITs more broadly), rising interest rates will make it more expensive to borrow and could therefore hamper their ability to buy more real estate -- and ultimately slow their growth.
Yet each company has a solid strategy in place to combat these issues. Coca-Cola, for example, is slimming down its global workforce by largely exiting the bottling portion of its business, focusing its attention on its core competencies around developing beverages and selling brands. And by creating and promoting smaller drink options -- think the smaller cans, or the "Share a Coke" campaign -- Coca-Cola looks to be on track to stabilize its core business. P&G is also homing its focus on its core competencies, selling tertiary beauty products to Coty for $13 billion. All this shedding should enable management to put renewed focus on 10 core areas where it is already a major player -- sectors such as baby care, hair care, and fabric care, anchored by about 65 core brands. These areas have driven the best growth for Procter & Gamble in the past, and management hopes to double down and continue to spur additional growth and cost savings in the coming years.
Johnson & Johnson and CVS are both responding well to their incoming threats as well. CVS bought Target's pharmacy network last year and continues to build additional stores (estimated at 100 new pharmacies in 2016 alone) to continue fighting for market share with the No. 1 retail pharmacy chain in the United States, Walgreens. Its continued emphasis on becoming a one-stop healthcare shop -- from the rapid expansion of Minute Clinics and their integration in an increasingly interconnected healthcare system to CVS' widely applauded move to stop selling tobacco products -- could be a key differentiator in the eyes of consumers.
Johnson & Johnson is planning to file 10 new drugs for approval by 2019, each of which has the potential, per management, of at least $1 billion in annual sales. If J&J is able to execute, that could be some impressive growth. J&J's CEO recently noted at the Goldman Sachs Healthcare Conference that he believes that "the strength of the pipeline, the follow-on indications and the growth of the base business is still sufficient to propel that business, the pharma business, to above market rates of growth" over the next several years (this and other quotes courtesy of S&P Market Intelligence).
As interest rates creep up in the coming months and years, Realty Income Group is in a unique position because of its scale and strong credit rating. Given that the company has plenty of space on its balance sheet to take on more debt -- in fact, CEO John Case recently described Realty Income's 24% debt-to-market-cap and 5.3X EBITDA ratios as "historically low" -- and has an excellent credit rating, Realty Income should be in a better position than most of its fellow REITs when interest rates start rising in earnest.
The best defensive stocks are great anchors
Big stocks like these five make sense to stabilize an investing portfolio when market volatility spikes. While they aren't going to be your big winners in one given year or another (could you imagine a company the size of J&J tripling in a year?), they're an excellent way to post solid, consistent gains over a long period of time. And at the end of the day, if you're investing with a long time horizon, that's kind of the point.
