Get in a Defensive Stance

Offense may be more fun to play, but in this tumultuous market environment, defense is the way to win the game.
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As we entered 2009, there was a collective sigh of relief amongst investors. The ugly stock market that was 2008 was behind us at last. There was a hint of investor optimism as we entered the new year, suggesting that perhaps the worst was behind us and we could look forward to a market and economic recovery.

These hopes have been rather rudely dashed just two weeks into the year. The economic news continues to be nothing short of horrible and the outlook for the next several months is for more of the same. Even as the bleak news on employment was being announced, there was a fresh wave of layoff announcements from U.S. corporations. The unemployment rate is now north of 7% and climbing. It's not just job cuts either. The average work week fell to the lowest level since 1964 as hours were cut and companies shifted to part-time employees to reduce costs.

As we all know, the real estate market has been the driver of the selloff in stocks. The situation there is not getting any better. Home prices continue to fall and foreclosures are coming at a record pace. It is estimated that as many as one out of every 10 homeowner s with a mortgage is at least days late with a payment as we entered the final quarter of the year. According to research firm RealtyTrac, as many as 3 million homes in the U.S. will be foreclosed. That is 60% of current inventory levels and represents enormous potential downward pressure on home prices.

The bad news can be seen in the market

All of this in reflected in the stock market. After initial attempts to rally into the new year, the second week of the year bought us renewed selling. Stock prices fell over 4% for the week as the effect of poor economic news and earnings warnings from many companies was felt. We have rallied about 20% off the absolute lows in November lows, but there is growing concern about the upcoming earnings season that could well be the end of what I see as a bear market rally.

The question for investors now is what to do with their money as the year progresses. It is not an easy question. Treasuries are out unless you are comfortable with yields of 3% or less. It is also highly likely that we see prices continue to fall on the long end of the market as bond issuance reaches record levels this year. Corporate bonds have rallied some, but there are still downgrades and defaults looming over that market. Stock and mutual find investors already know what the claws of the bear feel like, with losses in many cases of 40% or more.

For experienced, adept traders, this type of market will create opportunities. However, most of us are not traders of that nature or skill level. We have jobs, families and other concerns that do not allow us to track markets on a minute-by-minute basis. We are long-term in nature, hoping to rebuild out nest egg so we can retire some day and send our kids and grandkids to college. What do we do in this environment?

Defense wins the game

Let's take a lesson form the sports world. While offense is fun to watch and in good times can puts points on the board, if you cannot play defense, you quickly lose the lead. The San Diego Chargers with Dan Fouts at quarterback were exciting to watch, but they never won a Super Bowl because they could not play defense -- they gave up more points than all that offensive talent could produce. Pistol Pete Maravich was one of the greatest shooters in basketball history. He experienced one winning season in the NBA because the teams he played for had no defense. In this year's NFL playoffs, the teams that made it and are favored to win all have great defenses. Now, as investors, we need to learn and play great defense.

To play defense in the stock market, even long-term investors need to learn a few lessons from traders. Make our maniac business partner, Mr. Market, work for us instead of against us. Buy when the market is down. Ignore the breakouts and uptrends so often talked about in the financial press. In a bear market, buying on up moves is going to cost you money. John Templeton used to find stocks he liked and place good-till-canceled orders well below the market price. We should use the same mindset.

Playing defense also means moving slow and staying small. If you usually buy 500 shares of a stock, only buy 100 at first. Keep cash in reserve to add to the position at lower prices. If we have a long-term view of the market, the short-term opportunity to buy stocks lower becomes a good thing. Staying small and moving slow allows us to stay in the game and eventually profit from market turmoil.

The next step in playing defense in the market is only buying quality. Forget speculating on the next new technology or biotech breakthrough. Focus on companies that have been there for a long time and likely to be there when this is all over. With stock prices off 40% and possibly going lower, there will be profits enough from blue chips that speculating on secondary issues simply is not necessary. Look for solid, large companies that have strong balance sheets and, most important, pay a dividend. Dividends are money that market fluctuations cannot take back from you.

Drug stocks - a classic defensive stock

The classic defensive play of drug stocks is a good place to look right now. Companies like Pfizer (NYSE:PFE), Merck (NYSE:MRK), Eli Lilly (NYSE:LLY) and Bristol Meyers (NYSE:BMY) are good defensive choices. They pay generous dividends and are in a position to grow by acquisition in an era of cheap asset prices.

Research and development is one of the biggest expenses for major drug companies. Right now, it is probably cheaper to just acquire new drugs and technologies than to develop them. These companies are in a position to do exactly that. As more drugs come off patent and generic competition increases, buying a new pipeline while prices are low will drive growth for years to come. All three stocks have held up better than the market and yield more than 5%. Most important, all three will still be here when the market eventually recovers.

Bristol Meyers seems particularly well positioned in today's market. The company is realizing a profit of over $1 billion from shares of Imclone acquired during its failed takeover attempt. The company already has over $8 billion in cash on its books and this bonanza merely strengthens their position. The company was printable in 2008 with earnings growing by roughly 15% according to analysts. It should grow by at least that much in 2009.

Bristol Meyers are selling divisions that do not fit into its long-term plans and hoping to acquire companies that do. With a strong balance sheet, the company should be able to more than offset the patent expiration of Plaxil in 2011 through acquisition and development. Currently the company has more than 35 drugs in development with eight in the late stages of the testing and approval process.

Keep your wits about

Always keep in mind that playing good defense means playing smart. Buy when the market is down. Stay small and move slowly. A long-term approach in a bear market gives you a chance to accumulate shares in good companies at advantageous prices. Focus on high quality stocks that pay generous dividends. Although I favor Bristol Meyers, followed by Pfizer, all four of these pharmaceutical giants more than qualify.

Important Disclosures:

Neither Mr. Melvin nor is affiliated with Charles Schwab & Co., Inc. The views expressed here are those of Mr. Melvin, and do not necessarily reflect the views of Charles Schwab & Co., Inc. They are presented as a service to Schwab Active Trading clients. Schwab makes no judgment or warranty with respect to the accuracy, timeliness, completeness or suitability of the information presented. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Past performance is no guarantee of future results.

Schwab does not recommend the use of technical analysis as a sole means of investment research.

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  • The rough market environment will create opportunities, but long-term investors need to get defensive to take advantage of them.
  • Being a defensive investor means staying small and moving slow, as well as buying quality, proven stocks rather than speculating on the next big winners.
  • Drug stocks are classic defensive plays - Bristol Meyers has a strong balance sheet and many products in the pipeline, and is restructuring to meet its long-term plans.