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3 Defensive Stocks in an Overvalued Market
Posted by: Value Investor (IP Logged)
Date: April 28, 2014 02:52PM

U.S stock markets are at an all-time high. But according to Jim Grant the market is imputing a false value to the securities. The value of any stock depends on the future cash flows discounted by a suitable interest rate. But the American stock market is discounted with an artificially suppressed rate. And this will have its effect in the months to come. Also, according to him, markets are highly valued.

Since January, 2014, we have turned an unfriendly face to the market. We think the stock market is at a point where it is easier to find shorts than longs. There is more risk than reward as there are many candidates in the world for financial disruption. China being at the top of the list, it is an accident waiting to happen. Its credit system has been overlending and overborrowing at the wrong rate of interest on the wrong collateral and for the wrong purposes. Loans have been made against inflated collateral or against raw material specifically imported into the country to serve as collateral, for example: iron ore or copper.”

Now let us have a look at another market valuation technique: Shiller PE. It serves as a good guide for investors to decide on the kind of stocks to invest in.

“The Schiller P/E is a more reasonable market valuation indicator than the P/E ratio because it eliminates fluctuation of the ratio caused by the variation of profit margins during business cycles. This is similar to market valuation based on the ratio of total market cap over GDP, where the variation of profit margins does not play a role either.”

Current Shiller PE is 25.3, 53.3% higher than the historical mean of 16.5, indicating an overvalued market situation.

Considering the current economic condition where the market can correct itself by a huge margin, investors should book profit from high return-yielding stocks and also consider moving from high-beta to low-beta stocks. I would recommend the below three stocks as a good opportunistic shift to less volatile market.

Procter & Gamble

Procter & Gamble (PG) with a beta of 0.4 looks attractive in an overvalued market. The company’s recent third quarter 2014 results have reported core earnings per share increase of 5% and organic sales increase of 3% over the last year. In addition to this the company has an average dividend yield of 3.1%.

In 2014, P&G plans to repurchase shares which would increase the shareholder value by $6 per share in addition to the dividend of $7. This increases the shareholder yield to approximately 6% (considering a market cap of $220 billion).

Moreover, sales in emerging markets have helped Procter & Gamble to overcome weakness in the U.S. market. In countries like China and Brazil, sales grew by 8%, excluding the effect of currency, acquisitions and divestitures. Increasing household income and spending will act as a significant growth driver for the company and is expected to continue growing the sales at the rate of 7% to 8%. This growth, coupled with good dividends and low beta makes P&G a good investment option.

Johnson & Johnson

Johnson & Johnson (JNJ) is also a good pick in the current turbulent market situation. The company has been increasing its shareholder value and has a low beta profile of 0.56. JNJ also has a compelling dividend history and with a strong cash flow investors need not be worried about the dividends. This is evident from a 6.1% increase in the quarterly dividend rate.

Source : Company Website

The pharmaceutical segment is the key revenue driver for Johnson & Johnson, and the pharmaceutical sector is defensive along with being relatively recession-proof; SIRTURO has received the approval for treatment of multidrug resistant tuberculosis in the European Union. Similarly VOKANAMET and IMBRUVICA have also received the approval for the treatment of diabetes and chronic lymphocytic leukaemia in the European Union and U.S., respectively.

JNJ valuation looks high but still the company has the ability (as evident with increasing dividend and price gain) to pay dividends and earn enough to keep investors’ confidence. The relatively high PE indicates that investors are willing to pay more per dollar earning in order to remain invested in a quality and defensive stock.

Colgate Palmolive

Colgate - Palmolive Co. (CL) together with its subsidiaries manufactures and markets consumer products. The company operates in two segments: Oral, Personal and Home Care, and Pet Nutrition. Oral Care contributes the most to the company’s revenue, and hence my focus will be on the strategy the company is using to gain competitive advantage in the oral care sector.

The company has plans to increase its penetration and is working on the pricing to gain market share in emerging markets which largely constitute Brazil, Russia, India and China. Increasing GDP over the years in these BRIC countries indicates increasing per capita income and hence increases in spending power.

Organic growth in emerging markets has grown by 9.5% in fiscal 2013 and with the company's plans to work on the penetration and pricing powers it is expected to increase further. In order to cater to the rural areas in India the company has come up with low price units and has also started its marketing through Colgate vans to increase their coverage to remote areas as well.

In the last five years the company has increased its percentage of penetration in rural areas to 83% which is expected to increase with larger and more effective marketing campaigns. In addition to the above-mentioned drivers, innovation would be the biggest contributor in emerging markets. The company offers customized oral care products at customized rates which means the product is targeted not only to a particular group of individuals but on a larger scale, thus increasing their coverage scale. And as the per capita consumption increases, growth in earnings will follow.

Source : Company Presentation

Conclusion

I would just like to sum up by saying that in the present economic condition, the above stocks seem attractive with reasons pertinent to them. Also, since P&G and Colgate Palmolive plan to expand their reach in the emerging markets, earnings would continue to increase and so will the shareholder value. Thus, it would be wise to restructure the portfolio from high-beta to low-beta stocks to combat present turbulent market conditions.



Stocks Discussed: PG, CL, JNJ,
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