Over the last few years since the 2008 crash many people have been playing “defense” with their investments out of fear that another crash is around the corner. The problem is that the market has rebounded regaining much of its losses and the common investor is beginning to lose his caution. Once everyone is aggressive again it will be time for another crash. In today’s article Dennis Miller looks at some ways of playing good defense with your investments and earning a good return at the same time. ~Tim McMahon, editor
When the Offense Changes, the Defense Needs to Adapt
By Dennis Miller
While the investment world can seem like the same old game with the same old rules, it’s always changing around the edges. If you don’t adapt, you won’t win this game either. With the ten-year US Treasury recently closing as high as 2.98%, we face new threats, and the definition of a good defensive stock has changed accordingly. Now they must be defensive and immune to higher rates.
High-yielding stocks are often the most interest-rate sensitive, which makes the game even more challenging for retirees. So, how do you stay defensive while still receiving yield? I turned to our crackerjack team of analysts for some answers.
Let’s start with where defensive stocks stood prior to the rapid rate increase. With yields near record lows, investors piled in to dividend stocks in search of income. But they didn’t pick just any stocks. With 2008 still fresh in investors’ minds, they specifically chose defensive stocks with a beta of less than 1. For a quick review, a beta of one means a 10% move in the stock market should theoretically move the stock 10%. A beta of 0.5 means a 10% move in the market should move the stock only 5%.
But it wasn’t just retail investors choosing defensive stocks with a beta of less than 1. More sophisticated analysts suggested moving into these stocks as well. One of the most common Wall Street valuation models examines three primary factors: dividends; beta; and the US Treasury rate. When the beta and Treasury rates are low and the dividend is high, a stock is considered to be more valuable. This model worked quite well. In fact, a number of stocks in the Money Forever portfolio that are well in the green were partially evaluated this way.
When Treasury rates rose, every stock evaluated by that Wall Street model was necessarily worth less. When risk-free Treasury yields are a little higher, risk in the market for yield necessarily looks worse. With that said, some dividend stocks were hit much harder than others. In particular, utilities and REITs took the biggest dives, but they weren’t the only ones. Even our dividend stocks were a bit shaken up, but not nearly as bad as some others.
Why did some dividend stocks get hit while others stayed afloat? It goes back to that Wall Street valuation model. Some of our stocks were partially evaluated using the same approach. The very key word here is “partially.” We had other great reasons for investing in them. The beta and dividends were nice, but they weren’t the only worthwhile qualities. Our Five-Point Balancing Test is a big reason for this difference. We were specifically searching for stocks with some appreciation potential.
In contrast, utility stocks don’t fit that bill. Their main purpose was a safe dividend. For many years, utility stocks were referred to as “widow’s stocks.” They were a safe investment with a decent yield. Many investment counselors put a lot of their clients’ money into these types of investments. Because they were considered safe, those counselors were unlikely to be accused of mismanagement.
When interest rates tumbled, many additional billions of dollars were poured into utility stocks, and their prices rose. In a sense, they began to act like bonds. And since rising interest rates hurt bond prices, the same was true for dividend stocks. The most defensive companies with the least growth and the highest dividends were the hardest hit. While many investors felt safe because their money was invested in solid companies, they were not protected from interest-rate risk.
Unfortunately, that was common wisdom for lots of investors: find the biggest yield and the most defensive stock. There are two solutions to this problem:
- Find stocks where the growth outweighs the interest-rate sensitivity. If a stock’s primary value driver isn’t the dividend, it will be less affected by rising rates. Similarly, if a company has good growth prospects and a high dividend, it will be minimally affected.
- Find defensive stocks without a large dividend. As investors sought yield, they piled into defensive, high-yielding stocks. If an investor just wanted a defensive stock, he often found himself piled on the same heap as the yield-seekers. One way to avoid the problem of rate sensitivity and overvalued defensive yield stocks is to search for places where yield-seekers aren’t looking, i.e., defensive stocks with a small dividend. These stocks don’t necessarily have tiny dividends—just not enough to catch the eye of yield-starved investors.
However, note that there is a caveat to the first solution I just mentioned. You still need to concentrate on defensive industries. A company can have good dividends with growth and appreciation, but it might be a terrible investment in a downturn. The financial sector is a perfect example of this. The dividends are good and a strengthening economy can give the sector growth, but those dividends won’t pay off should another 2008 be just around the corner.
With that in mind, our team produced The Cash Book, a comprehensive guide that reveals how to protect your wealth in this new age of finance. It’s a handy guide filled with ideas you won’t hear about from your financial advisor, like how to legally get around the FDIC’s $250,000 cap on insurance, the 10 safest states to do your banking, and how the average person can open an account in Switzerland without attracting extra scrutiny from the IRS.
Normally The Cash Book is only available to Money Forever subscribers, but because it’s now more important than ever to diversify our retirement nest egg away from traditionally “safe” investments, we’ve made it available on its own. Get these easy-to-use strategies for protecting your wealth from the many threats facing us today: click here for your copy.
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