Ever since the financial crisis three years ago, nervous investors have gravitated toward industries that tend to hold up well during market downturns. But the resulting flood of money into defensive stocks has pushed valuations in the sector upward to the point at which the stocks aren't nearly as attractive as they once were -- and may not perform the way risk-averse shareholders would expect.
Looking for the perfect armor
The Holy Grail of investing is a stock that will deliver high returns without the volatility and risk that investors have become all too familiar with in recent years. With economic cycles seemingly becoming longer and more extreme, with a long period of expansion followed by the worst recession in decades, nearly everyone would love a stock that could give them stable, comfortable returns without the anxiety that keeps many investors awake at night.
Consumer staples stocks have a lot of those attractive attributes. They tend to move less violently than the market, lagging behind high-growth stocks during big bull markets but holding up far better in the inevitable downturns that follow. From a business perspective, these companies do a better job of sustaining sales and income even during bad times for one simple reason: The products they make are ones that consumers want and need. Cutting back just isn't an option for many customers, which helps keep those companies healthy.
Safety at any price?
The problem, though, is that even safe stocks can get expensive enough that they start being riskier than you'd expect -- and can stop giving you the returns you want. For instance, since 2012 began, the overall stock market has performed quite well. But many consumer staples have lagged behind. Consider these examples:
- Just yesterday, Kimberly-Clark (NYSE: KMB) said that the rising costs of raw materials would cause its 2012 earnings to fall below what analysts had expected. Already, the company has seen a big impact from those costs, with 2011 earnings falling 14% from previous-year levels. Yet even after a decline yesterday, the stock still fetches more than 17 times trailing earnings.
- Dow component Procter & Gamble (NYSE: PG) has fallen about 2.5% since the beginning of 2012, severely underperforming the Dow Industrials overall. Although its pricing power gives it more protection from raw material inflation than Kimberly-Clark, P&G nevertheless still trades at a P/E of 16 even after its decline so far this year. Moreover, analysts expect a small decline in profits versus last year's levels when the company reports on Friday.
- Colgate-Palmolive (NYSE: CL) weighs in with an earnings multiple of nearly 18, despite facing many of the same challenges as its peers. Clorox (NYSE: CLX) is even pricier, sporting a 20 P/E on long-term growth expectations that fall behind both Colgate and P&G.
- Even must-have product sellers are seeing pressure. Cigarette maker Altria (NYSE: MO) is down almost 5% for the month so far and trades at a P/E of 17. It too announces earnings on Friday, but analysts are more optimistic, expecting modest growth from the tobacco giant.
One thing that all of these stocks share is that they pay good dividends. In this income-starved environment, high-yielding dividend stocks have gotten more popular than ever. That makes sense given the reputation that dividend payers have as ballast in a downturn.
I'm not saying these are bad stocks. But any hot investment can get bid up too far. If the economy fails to deliver on the promises investors expect from it, then these stocks could drop further than they have in previous downturns. And conversely, with such strong gains already incorporated into their stock prices, defensive plays may lag even worse than growth stocks in the next big bull market.
Be safe
None of this should stop you from managing your risk level to match what you're willing to live with. But keep in mind that no matter how safe a stock may have been in the past, there's still an upper limit on what you should be willing to pay for it. If you remember that, then you should avoid making the mistakes that led so many investors into trouble during the last bear market.
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