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You can easily tell the defensive stocks listed on the Toronto Stock Exchange — they're the ones that look totally lame right now.
In a go-go stock market like we've seen in the past few years, defensive stocks tend to perform so poorly that you could accurately describe their returns as offensive. Don't worry — when the markets run out of gas, the classic defensive stock springs into action and starts limiting the overall damage to your investment portfolio.
There are several kinds of stocks that qualify as defensive — utilities, pipelines, consumer staples and health care, including pharmaceuticals. You'll probably notice a theme here — each sector is involved in an economic activity that isn't affected by the economic cycle that influences the overall stock market. Utility companies generally have locked-in pricing agreements with their customers, so they're able to operate on an even keel from year to year. Consumer staples companies are often in the food business, which is steady, while health care offers a similar level of constancy. Some experts would include financial stocks in the defensive category because even while they're affected by economic ups and downs, they're steady earners.
To see a defensive stock in action, let's head back to 2001, a nasty bear-market year in which the S&P/TSX composite index fell 12.6 per cent. As the index was falling that year, the pipeline stock Enbridge Inc. was holding up well. The company's shares edged lower by just 0.7 per cent and, if you add the impact of dividends, then the total return was about 2.5 per cent.
True to form, Enbridge hasn't had a great 2006 so far. The shares had a 12-month gain of 1.7 per cent heading into the end of July, while the S&P/TSX composite gained 12 per cent. That's to be expected, though. Enbridge's time will quite likely come when the markets weaken.
You don't want to have a lot of defensive stocks in your portfolio all the time, but some are good enough companies than you can own them over the long term and receive both solid down-market protection and decent overall returns. Enbridge, for example, has produced a cumulative increase in its share price of 77.8 per cent, which is impressive. The S&P/TSX Index, by comparison, is up only 53.1 per cent over the same period.
How is it that a defensive pipeline stock can outperform a stock index that has been just flying lately? Simple — Enbridge never fell as much as the index did in the early years of this decade.
Don't get the idea that all defensive stocks are solid long-term performers, though. Some pharmaceutical stocks have been dogs in the past five years, and some utility stocks have delivered only modest share price growth to augment their dividends. In the consumer staples area, Loblaw has recently seen its share price fall to a five-year low as a result of internal problems.
How do you find the best defensive stocks? Simple — look for the ones that increase their quarterly dividend payments every year or so. Again, Enbridge is a good example because the company has boosted its annual dividend payout by an average 10 per cent annually over the past 50 years . Any company that can do that isn't just defensive, it's also quite possibly a good investment opportunity in its own right.
Rob Carrick has been writing about personal finance, business and economics for more than 12 years.