A Refresher on Defensive Investing

NEW YORK (Real Money) -- With the announcements Wednesday morning from the U.S. Commerce Department's Bureaus of Economic Analysis and Census that real first-quarter annualized GDP was revised to a contraction of 2.9% and that durable goods orders for May -- the second month of the second quarter -- decreased by 1% since April, now is a good time to review defensive investing.

One of my general themes of the past few years has been taking a defensive position by investing in sectors that are traditionally affected less by poor economic activity because the goods produced by them must be consumed. My preferred defensive sector has been grocery stores, which I last wrote about in January. In that sector, the two names I like the most continue to be Safeway (SWY) and Kroger (KR). So far this year, Safeway and Kroger shares are up about 17% and 25%, respectively, compared with the S&P 500's approximately 6.5% return. That's a stellar performance for any stock, but truly impressive for mature companies in a low-margin business.

The dividend yields have also remained relatively stable over the past year. Safeway's is currently 2.7% vs. 2.5% about a year ago. Kroger's is now at 1.3%, down from 1.6% at this time last year. Both are down substantially over the past 18 months, when Safeway was paying a dividend yield of about 3.4% and Kroger's was about 2.2%.

The sector, especially Safeway and Kroger, has become crowded with investors looking for income alternatives to bonds. This has driven their stock prices up, and that is reflected by lower dividend yields. The investors most responsible for this are logically parking their money in these issues temporarily. These issues increasingly look less defensive than they did a few years ago. These companies and this sector, however, still represent the least risk of a capital market disruption caused by poor economic activity, so holding them for income is still warranted.

The performance of Whole Foods (WFM) and The Fresh Market (TFM) this year has been the exact opposite; their stock prices are down by 32% and 15%, respectively. As I wrote in January, deteriorating economic activity would likely preclude consumers from upgrading their grocery purchases to these higher-priced providers.

The divergent trends in the stock prices of these two groups indicate that their real risk profiles are converging. Whole Foods in particular is beginning to have a financial profile similar to Kroger. I still don't consider Whole Foods as a defensive position, and I believe there's still downside for it as the real condition of economic activity and the potential for a capital market reaction to it begins to be recognized by investors. But it warrants watching as a buying opportunity within the next three months, and I may advise swapping Kroger for Whole Foods within that period, especially if their stock prices continue to diverge.

The Fresh Market, however, still represents too much risk, and I believe that could decline substantially from current levels. Eighty percent of its stock is held by institutions, which is on par with the other three discussed, but its market cap at about $1.65 billion is a fraction of the others and represents a liquidity risk to investors.

Costco's (COST) share price has declined by about 1.3% so far this year. The biggest issue facing it is the lack of household formation, which itself is a derivative of the poor economy and lack of job prospects for the 25- to 34-year-old demographic. Costco's primary customers are families with high grocery bills. Fewer family formations and less consumer income mean less need and less ability to pay for bulk purchases of grocery items.

Walmart (WMT) shares are off by about 3.7% this year. The biggest issue facing Wal-Mart is that it is already massive, making growth extraordinarily difficult as there are few other players in the general discount consumer segment competing for market share. It's also being hit by the same economic realities affecting Costco: lack of consumer disposable and discretionary income.

Now let's look at TheStreet Ratings' take on some of these stocks.

TheStreet Ratings team rates SAFEWAY INC as a Buy with a ratings score of B-. TheStreet Ratings Team has this to say about their recommendation:

"We rate SAFEWAY INC (SWY) a BUY. This is driven by a number of strengths, which we believe should have a greater impact than any weaknesses, and should give investors a better performance opportunity than most stocks we cover. The company's strengths can be seen in multiple areas, such as its revenue growth, solid stock price performance and largely solid financial position with reasonable debt levels by most measures. We feel these strengths outweigh the fact that the company has had sub par growth in net income."

Highlights from the analysis by TheStreet Ratings Team goes as follows:

  • SWY's revenue growth has slightly outpaced the industry average of 5.5%. Since the same quarter one year prior, revenues slightly increased by 1.0%. This growth in revenue does not appear to have trickled down to the company's bottom line, displayed by a decline in earnings per share.
  • Compared to its closing price of one year ago, SWY's share price has jumped by 44.69%, exceeding the performance of the broader market during that same time frame. We feel that the stock's sharp appreciation over the last year has driven it to a price level which is now somewhat expensive compared to the rest of its industry. The other strengths this company shows, however, justify the higher price levels.
  • SAFEWAY INC has experienced a steep decline in earnings per share in the most recent quarter in comparison to its performance from the same quarter a year ago. The company has suffered a declining pattern of earnings per share over the past two years. However, we anticipate this trend to reverse over the coming year. During the past fiscal year, SAFEWAY INC reported lower earnings of $0.95 versus $1.20 in the prior year. This year, the market expects an improvement in earnings ($1.14 versus $0.95).
  • SWY's debt-to-equity ratio of 0.78 is somewhat low overall, but it is high when compared to the industry average, implying that the management of the debt levels should be evaluated further. Regardless of the somewhat mixed results with the debt-to-equity ratio, the company's quick ratio of 0.87 is weak.
  • Current return on equity is lower than its ROE from the same quarter one year prior. This is a clear sign of weakness within the company. Compared to other companies in the Food & Staples Retailing industry and the overall market, SAFEWAY INC's return on equity significantly trails that of both the industry average and the S&P 500.

TheStreet Ratings team rates KROGER CO as a Buy with a ratings score of A-. TheStreet Ratings Team has this to say about their recommendation:

"We rate KROGER CO (KR) a BUY. This is based on the convergence of positive investment measures, which should help this stock outperform the majority of stocks that we rate. The company's strengths can be seen in multiple areas, such as its revenue growth, solid stock price performance, growth in earnings per share, increase in net income and good cash flow from operations. We feel these strengths outweigh the fact that the company has had generally high debt management risk by most measures that we evaluated."

Highlights from the analysis by TheStreet Ratings Team goes as follows:

  • The revenue growth came in higher than the industry average of 5.5%. Since the same quarter one year prior, revenues slightly increased by 9.9%. This growth in revenue appears to have trickled down to the company's bottom line, improving the earnings per share.
  • Investors have apparently begun to recognize positive factors similar to those we have mentioned in this report, including earnings growth. This has helped drive up the company's shares by a sharp 41.36% over the past year, a rise that has exceeded that of the S&P 500 Index. Regarding the stock's future course, although almost any stock can fall in a broad market decline, KR should continue to move higher despite the fact that it has already enjoyed a very nice gain in the past year.
  • KROGER CO has improved earnings per share by 6.5% in the most recent quarter compared to the same quarter a year ago. The company has demonstrated a pattern of positive earnings per share growth over the past two years. We feel that this trend should continue. During the past fiscal year, KROGER CO increased its bottom line by earning $2.90 versus $2.77 in the prior year. This year, the market expects an improvement in earnings ($3.23 versus $2.90).
  • The net income growth from the same quarter one year ago has exceeded that of the Food & Staples Retailing industry average, but is less than that of the S&P 500. The net income increased by 4.2% when compared to the same quarter one year prior, going from $481.00 million to $501.00 million.
  • Net operating cash flow has increased to $1,780.00 million or 10.08% when compared to the same quarter last year. Despite an increase in cash flow, KROGER CO's average is still marginally south of the industry average growth rate of 11.91%.

At the time of publication, Arnold was long COST, although positions may change at any time.

Editor's Note: This article was originally published at 6:00 p.m. EDT on Real Money on Wednesday, June 25. ​​

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Roger Arnold is the chief economist for ALM Advisors, a Pasadena, Calif.-based money management firm specializing in income-generating portfolios. Concurrent with his other business responsibilities, Arnold was a radio talk show host for 15 years. He focuses on behavioral economics and chaos theory, better known as the "butterfly effect." He explains the relationships between political, economic and social systems, and how they are all reflected in the financial markets -- stocks, bonds, commodities, currencies and real estate.

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