Super stocks to survive the downturn

So far, 2008 has been one of the worst years for stockmarkets we've seen in a long time. That's no exaggeration the 7.5% fall in the FTSE 100 in the first few weeks of January was the biggest seen since the index formed in 1984.

With many global stockmarkets now firmly in bear market territory (having fallen by more than 20% from their 12-month highs), it's small wonder that all the talk is of capital protection and shifting into defensive stocks.

But what is a defensive stock? Ideally, you're looking for companies that will see demand for their products remain stable, even in a recession. You want stocks that generate plenty of cash, so they're going to stay solvent and be able to keep paying out dividends and hopefully grow them too. And as Tim Price of PFP Wealth Management says, "size tends to matter in a bear market the larger capitalised companies have higher presumed quality and normally enjoy greater geographic and business line diversification".

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There are plenty of traditional defensive sectors John Rothchild in The Bear Book: survive and profit in ferocious markets, highlights food suppliers, tobacco groups and utilities, among others. It's easy to see the appeal of these stocks. People don't give up smoking easily, and in some ways it's even harder to do so in the depths of a recession after all, going without a pleasure is harder when the world around you is a pretty cheerless place. Utilities are in a similar boat. People don't stop using energy and water during a recession and so investors are attracted to the steady and reliable earnings and dividend streams that such companies generate.

But the trouble with traditional defensive plays is that everyone knows about them. So now that the hard times have arrived, "institutional investors have already crowded into the more obvious defensive stocks (tobacco and utilities), so there are few compelling valuations there", says Price.

Moreover, tobacco and utilities stocks haven't exactly been out of favour in recent years both sectors have been lifted by mergers and acquisitions (M&A) activity. If anything, that bid premium may well vanish now that it's becoming harder for firms to raise money to fund takeovers. And even if the stocks stay where they are, they aren't likely to do anything very exciting.

The truth is that every bear market is different. Just as different sectors perform badly in each bear market last time it was tech stocks, this time it's financials there are others that should be able to survive, and perhaps even thrive, in the storm. So which sectors would we be looking at buying into now?

Defensive investing: drugs

Healthcare stocks are a classic defensive sector. But unlike fellow defensives, tobacco and utilities, big pharma stocks have had a miserable time in recent years. At first sight, it's hard to see why. The broad backdrop for drug companies is very encouraging, for obvious reasons. Increasing lifespans, shrinking fertility and bad diets mean that the population in the West is in general terms getting older, sicker and fatter; and the population in the East is likely to follow us down the same path as they become wealthier.

So demographics are very much in favour of companies that provide us with drugs to keep us young, healthy and slim. And, of course, they're good to hold onto in a recession because people will always buy drugs even if you're feeling poor, you'll still buy medicine if you need it.

But there are equally good reasons for investors' general disappointment with the sector. There's the increasing problem of generic drug manufacturers making cheap copies of blockbuster drugs and challenging patents on them, while regulators are becoming slower to approve new drugs.

And this squeeze new drugs are taking longer and costing more to get to market, while patented ones are coming off patent more rapidly has made life difficult for big pharma and put off investors who had been hoping for more miracle cures by now. As US healthcare fund manager Sam Isaly tells Kiplinger's, "people thought the world would change sooner and at less cost than has actually happened".

"There's no doubt that the environment for pharma is harder than in 2001," says Felicity Smith at Bedlam Asset Management. But amid all that bad news, pharma companies have been pushed to their lowest p/e multiples for years. Sure, there may be plenty of headwinds facing the drugs companies, but it's priced in at current levels. "Five years or so ago, 70% of the value of the pharma stocks was in the bit of the drug pipeline that hadn't even been announced yet," says Smith. But as investors have become more pessimistic, "today people are paying about 30% of the value for future pipeline", says Smith. In short, the bad news is priced in and it wouldn't take much "good news to revalue the sector".

And with the investment pendulum swinging firmly from over-leveraged financial stocks to companies that churn out cash flow, big pharma is suddenly back in focus, which should help drag the sector out of the doldrums.

So which stocks look the best picks? In the UK, Tim Price says, GlaxoSmithKline (GSK) "ticks many of the right boxes" and looks "very fairly priced". As Edward Collins of New Star told Interactive Investor recently, "most of the pessimism in pharma stocks is about patent expiry, but I don't think that stands up as a generalisation Glaxo has 30 late-stage drugs in its pipeline, while Astra has five, and yet both are treated in the same way by the market".

Another bonus for Glaxo (and pharma stocks in general) is that much of its earnings are denominated in dollars. With sterling one of the few currencies likely to weaken against the dollar this year, Glaxo could see the foreign exchange exposure boost its results. It trades on a forward p/e of 12.2 and yields 4.3%.

Smith likes Switzerland-listed Novartis (VX:NOVN). The stock took a hit last year as its irritable bowel syndrome drug Zelnorm was withdrawn. But it has a solid drugs pipeline and a well-diversified range, with more than 20 main products making up most of its sales.

Its range of business units also means it is not solely reliant on new drug discovery it has a growing vaccines unit (generally seen as lower risk, as these have more chance of making it to market than other types of treatment); a generics division, which will help to offset patent expiry problems; and a very strong over-the-counter medicines business including brands such as Nicotinell and Ex-Lax. The company trades on a forward p/e of 13.7 and yields 2.9%.

Defensive investing: consumer staples

A recession spells bad news for most retailers and consumer goods firms. But there are certain things that people still have to buy, even in a downturn. Consumers still have to clean and they still have to cook if anything, they spend even more time in the kitchen as they cut down on eating out and takeaways.

So companies that make consumer staples should be a sound bet during a recession and the bigger the better, as exposure to faster-growing global markets can make up for weakness in others. That makes Reckitt Benckiser (RB/) "one of the most defensive stocks around", says Price. The group operates worldwide and has sales of more than £5bn. Its stable of leading brands includes names such as Dettol, Vanish, and Harpic, and it has good exposure to emerging markets.

Its main rival and one less well-liked by analysts is Unilever (ULVR). The Anglo-Dutch group's brands include Persil and PG Tips. Unilever has long lagged Reckitt, despite continued attempts to restructure the group, but the latest attempt by chief executive Patrick Cescau to improve things seems to be paying off. Shares magazine says changes such as laying off 27,000 people last year and focusing on fewer key brands, "should all convince doubters Unilever can achieve its 2010 profit margin target and generate 7% earnings growth this year and next".

However, while your money is probably safe with these two (if pushed, we'd favour Reckitt, due to its more consistent performance), on respective forward p/es of 20.6 and 16.9, and yielding 2.0% and 3.0%, neither stock could be described as stunning value.

Perhaps a more interesting play on consumer staples is Tesco (TSCO). It's not often you see retailers tipped in MoneyWeek, but Tesco is by far the most dominant supermarket in Britain, apparently accounting for one pound in every eight spent on the British high street. That position of supremacy could mean it even benefits from a downturn. As Price puts it, "given the fierce pricing of its products, it is hard to foresee Tesco shoppers deserting the brand for cheaper competitors, but more affluent shoppers could easily downshift toward the Cheshunt-based retailer".

The group also has exposure to emerging markets in Asia and Europe. Its new venture in California is something of a wild card, but the supermarket has entered the US market cautiously and if it does manage to pull it off, the benefits could be massive.

Tesco does suffer from the fact that as a perennial over-achiever, it's very easy for it to disappoint the City. The share price has recently fallen from north of £4.80 to around £4.15, after Christmas sales grew by less than expected. But on a p/e of 16, it trades at a discount to its peers, which, given its position in the market, makes no sense. Of all the grocery groups, it is certainly the best placed to weather a recession.

Defensive investing: fixed-line telecoms

Traditional utilities such as water and electricity providers don't look especially compelling, as mentioned above. But an interesting alternative play that meets the criteria of decent cash flow and sound dividend yields is fixed-line telecoms stocks. Large ex-monopoly telecoms groups, such as BT in the UK and KPN in the Netherlands, "were hated through the upturn", says Smith, with investors fearing that mobile-phone companies and new competitors would steal traffic and leave the older players in the dust.

But as is often the case, the negativity has been overdone. Market share for former monopoly telecoms is stabilising throughout Europe, helped by consolidation among new players, and increasing revenues from new services such as broadband. Meanwhile, with the lion's share of network upgrades complete, capital spending has peaked. "Free cash flow remains high, they pay generous dividends and you are starting to get a tiny bit of growth coming back in the new service. In an environment where economic growth is slowing down, they look good."

Ian Lyall in the Daily Mail agrees with Smith, pointing out that BT (BT/A) "seems to have been overlooked by investors, which is odd given the generous dividend payout it promises". On a p/e of 10.9 and a prospective yield of 6%, it's definitely worth a look.

Risky defensive stocks that could prove immune to the credit crunch

No one ever said investment had to be exciting. For many people, it's the last thing they want to think about. But if you're the sort of person who switches off when they hear the word defensive', here are a few stocks that while certainly risky should be virtually immune to the bursting of the credit bubble and any ensuing recession.

In the pharmaceutical sector, you can play safe and go for the Glaxos of this world. But another area that currently looks interesting is British biotech. Now this sector is undoubtedly high risk, but there are ways to improve your chances of picking a winner. The biggest problem for biotechs is running out of cash. So what you want is a firm that has enough money to fund its research, and which already has successful products bringing in a steady revenue stream.

The good news is that there are plenty of them about. Piper Jaffray analyst Sam Fazeli tells Investors Chronicle that "he has never seen so many companies that have not been in need of fund raising." Investors Chronicle picks out nine, including research tools group Immunodiagnostic Systems and wounds specialist Renovo.

But the one that stands out is Protherics (PTI). According to Investors Chronicle, the products (including a rattlesnake anti-venin) that Protherics already has in production are worth 52p a share alone. With Protherics' share price standing at just over 50p, that means you are getting its pipeline which includes anti-cancer treatments and a potential blockbuster treatment for blood poisoning for free (disclosure: I own shares in Protherics).

There are also a few risky, but probably crunch-immune stocks knocking around among the mid-cap food producers all of which have been hammered recently amid fears of rising raw materials prices. But recent results show pricing power is returning to them. After years of being squeezed by retailers, producers such as Premier Foods have managed to push through price rises, which suggests conditions are improving. We'd give Premier a miss: despite looking attractive on a p/e of eight and having a dividend yield of 9.9%, thanks to last year's acquisition of RHM, it is far more highly geared than its peers. That's not good in a credit crunch.

Rival Northern Foods (NFDS), maker of Fox's biscuits and Goodfella's Pizzas, looks more interesting. Goldman Sachs recently upgraded the stock from hold to buy in the belief that food producers will continue to be able to pass on raw materials costs. The stock trades on a p/e of 12.7 and yields 4.2%.

Another, riskier play on consumer staples is to invest in firms profiting from rising raw materials prices, such as agrochemical firms. While these stocks have risen sharply, they should have further to go. As Bedlam's Felicity Smith notes, fertiliser providers "are only just seeing real price increases last year was the first one they didn't take price cuts". One to consider is Mosaic (US:MOS), the world's top producer of potash and phosphate fertilisers.

Why you should still avoid banks and builders

Lots of FTSE stocks look cheap at the moment, there's no doubt about it. Tom Stevenson in The Daily Telegraph dug deep this week to find the cheapest and, unsurprisingly perhaps, housebuilders and banks dominate the list, which we've reprinted in the box below.

We often find ourselves agreeing with Stevenson's views, and his screening criteria such as making sure the dividend yield is at least two times covered seem to make sense, but we can't say we would back these picks.

On banks, as Tim Price puts it, "we are in the midst of an extraordinary banking crisis, and I still believe that there's insufficient earnings visibility to warrant purchases in the sector." And as soon as one bank cuts its dividend, that clears the way for the rest even the better capitalised ones to do likewise.

As for housebuilders, given that we seem to be on the cusp of the biggest housing slump the UK has seen since the 1990s, we think they could still have far further to fall.