When investors worry about a possible recession, they will often rotate out of economically sensitive stocks into sectors that are less affected by weakness. This would mean selling shares of manufacturers, banks, and luxury retailers and rotating into defensive sectors like utilities, grocery stores, and consumer nondiscretionary.
That said, defensive stocks don't necessarily have to mean stodgy consumer-products companies. Sometimes you can find opportunities in sectors generally not considered defensive, and sometimes you can find fast growers in historically defensive sectors. Here are three examples.
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A competitive moat
CME Group (CME) is one of the biggest options and futures exchanges in the world. The company runs the Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange.
In general, exchanges are insulated from the credit risk that bedevils other financial companies. CME Group's main products are equity indexes, interest rate derivatives, and foreign exchange derivatives, and the business is highly profitable with operating margins above 50%. These margins are evidence of its competitive moat. CME Group has a 1.9% dividend yield, and it trades at 23 times expected fiscal-year 2020 earnings. Wall Street is expecting 12% EPS growth in 2020.
A classic defensive stock
Colgate-Palmolive (CL 0.46%) is the classic defensive stock. It's known primarily for soap, toothpaste, and pet food. Oral care (Colgate toothpaste) accounted for 46% of sales last year, while personal care (deodorants, bar soap, and the like) was 20% of revenue. Pet nutrition (Hill's Science Diet) accounted for 16% of revenue.
Like most companies that are defensive investments, Colgate sells products that people will buy no matter what happens to the economy, and the lion's share of organic sales growth will come from emerging markets. For the most part, what you gain in stability you give up in growth.
These companies generally grow just about at the same pace as worldwide GDP. Colgate-Palmolive is trading at 25 times expected fiscal-year 2020 earnings and has a 2.5% dividend yield.
A growth stock
Growth and defensiveness don't usually go together. When you think of defensive stocks, it is easy to imagine a portfolio of mature brands and a company that grows more or less at GDP growth. With Beyond Meat (BYND -0.73%), this is a case of the defensive sector coinciding with a sea change in consumer attitudes, along with an economic opportunity caused by COVID-19.
The pandemic has hurt the restaurant business, but the company's U.S. foodservice segment saw revenue more than double in the first quarter. The issues with the meat supply chain have also created an opportunity for Beyond Meat. Shortages of meat and higher prices have made its vegetable-based meat substitutes more attractive, creating an incentive for consumers to try the product.
Beyond Meat stock has been on a tear this year, up 76% year to date. It's benefiting from a societal shift in perceptions about meat consumption, driven by environmental consciousness, health concerns, and an improvement in quality. Beyond Meat is not a cheap stock, but very few quality growth stocks are. The company is expected to be modestly profitable this year, and doesn't pay a dividend. It's an example of a stock with limited correlation to the overall economy that is experiencing early-stage growth. This would be a defensive choice to hang on to for a while.
Where are we headed?
The question now is whether the worst is behind us. If we don't see a resurgence of COVID-19 cases and states continue to reopen, then we are probably closer to the early stage of the recovery. If so, you want to look at early-stage cyclicals: stocks that are sensitive to interest rates and will benefit from the rate cuts a couple of months ago. This means some financials (the less credit-sensitive banks), homebuilders, and some consumer discretionary stocks.
The economy was almost picture-perfect heading into this downturn. We didn't have any of the typical economic rot (asset bubbles, lousy loans, overleveraged companies) that you usually see corrected in a recession. This would argue for a faster recovery.
