The Dow Jones Industrials (DJINDICES:^DJI) plunged 160 points on Friday, with momentum stocks leading the broader market downward and calling the entire bull market into question. But amid the chaos in which 26 Dow components lost ground, three of the four gainers in the Dow were stocks that investors traditionally see as being good defensive plays in shaky markets: Coca-Cola (NYSE:KO), McDonald's (NYSE:MCD), and Johnson & Johnson (NYSE:JNJ). Can these three stocks fulfill their usual function of providing protection for investors from the next bera market -- whenever it comes? Let's take a closer look.
The idea of defensive stocks is pretty simple. Some stocks don't have huge growth prospects, with steady and reliable streams of revenue and income that don't necessarily change all that much even as economic conditions rise and fall. People always need to eat, drink, and have basic first-aid materials on hand, and so McDonald's, Coca-Cola, and Johnson & Johnson all have baseline demand no matter how bad the economy gets.
But several things about defensive stocks have investors worried about how good a job they might do this time around in protecting them from a downturn. Valuations for these stocks are all reasonably high, with many investors already having jumped into shares in order to reap their high dividend payouts. All three stocks fetch between 18 and 21 times trailing earnings, which is pricier than the Dow as a whole.
At the same time, growth prospects for all three companies aren't assured. Johnson & Johnson recently sold off its Ortho diagnostics unit in order to refocus on its core pharmaceuticals business, which has the greater prospects for growth if the candidate drugs in its extensive pipeline pay off. But with plenty of competition in the pharma space, Johnson & Johnson has no assurance of being able to sustain high growth. Similarly, McDonald's has struggled to grow, with efforts to expand its menu running into difficulty as other players in the fast-food industry look to invade McDonald's breakfast space while higher-end fast-casual chains build up their competitive advantages. Coca-Cola faces the even bigger threat of falling carbonated beverage volumes, especially as health concerns about diet soda and the artificial sweeteners found in it have led many consumers to move away from the products.
The argument for defensive stocks
Despite these reasons to be wary of defensive stocks, the fact is that many investors still look to Johnson & Johnson, McDonald's, and Coca-Cola as ports in stock market storms. Based solely on that perception, it's entirely possible that if the Dow starts moving downward, these stocks will still outperform.
In the long run, though, you need to be careful with defensive stocks like these. With the premise underlying defensive strategies being modest but reliable growth, any threat to these companies could leave you realizing that they weren't strong defensive plays to begin with.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Coca-Cola, Johnson & Johnson, and McDonald's and has options on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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