Defensive stocks defend your portfolio from losses typically sustained during recessionary periods.They are ones that investors tend to want to own during uncertain times, and one that they definitely want to own during hard times. These are also deemed as non-cyclical stocks, so they are not as dependent on the overall economic cycle like certain tech stocks, and consumer discretionary or durable good makers.
If you decide to invest in defensive stocks, you must first make sure that you put those stocks to some several tests before you select them as it is the key to putting together a conservative portfolio of common stock.
This article focuses on some tests of selecting defensive stocks. Take note that these test guidelines only apply to passive investors seeking to put together a portfolio of solid companies for long-term appreciation.
Adequate Size of the Enterprise
In the world of investing, there is some safety attributable to the size of an enterprise. A smaller company generally goes through wider fluctuations in earnings while a large company is generally more stable by comparison.
It is best that an industrial company should have at least $100 million of annual sales, and a public utility company should have no less than $50 million in total assets. Adjusted for inflation, the numbers would work out to approximately $465 million and $232 million respectively.
A Sufficiently Strong Financial Condition
A stock should have a current ratio of at least two. Long-term debt should not exceed working capital. For public utilities, the debt should not exceed twice the stock equity at book value. This should act as a strong defense against the possibility of bankruptcy or default.
To help guarantee a company’s profits keep pace with inflation, net income should have increased by one-third or greater on a per-share basis over the course of past ten years using three-year averages at the beginning and end.
Moderate Price to Earnings Ratio
For inclusion in a conservative portfolio, the current price of a stock should not go beyond fifteen times its average earnings for the past three years. This acts as a defense against overpaying for a security.
Moderate Ratio of Price to Assets
Benjamin Graham once quoted, “Current price should not be more than 1 1/2 times the book value last reported.”
However, a multiplier of earnings below 15 could justify a similarly higher multiplier of assets. As a rule of thumb, it is best that the product of the multiplier times the ratio of price to book value should not exceed 22.5 (this figure corresponds to 15 times earnings and 1 1/2 times book value).
See Also: What Do We Mean By Defensive Stocks?
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