Three defensive stocks to buy now

As the stock market rally falters, it's time to get re-acquainted with the world of inflation-beating defensives, says Theo Casey. Here, he picks three stocks to shelter behind.

After seven range-bound weeks of the FTSE 100 wobbling up and down from 4300 to 4500 and back again, the market has finally rediscovered its direction. As I expected, it's fallen from its highs and is down at 4244 last time I checked. Today, we'll look at what's worth buying now

I've been consistently sceptical of the "green shoot" phenomenon over the last few months. It did bear all the hallmarks of a bear market rally; the stocks with the worst fundamentals (mainly financials) which were previously sold most heavily, rose the highest.

More to the point, fund managers, hedge fund managers and pension funds were not buying stocks. The rally was driven by short-termers that care little for long-term value. It was unchecked momentum that has finally been checked

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Alas, the losers in this story are the suckers who believed the hype and bought big.

However, it's not too late to sell out of those trashy stocks with terrible balance sheets. And there's one corner of the market that is not just fundamentally superior, it's also unlikely to feel the brunt of the downturn.

It's time to get re-acquainted with the world of inflation-beating defensives

'Cheap, cheap, cheap'

We've been long defensives for a while, but we're being increasingly joined by the City professionals. Citigroup, for example, recently published a European strategy report titled Cheap, cheap, cheap extolling the virtues of larger cap, Blue Chip stocks:

"Having enjoyed strong relative gains during the bear market, defensives have been left behind in the post-March rally.

"Many investors have also used defensives, especially large-caps, as a source of funds for the risk trade. As a result, defensive stocks and sectors have moved from looking expensive to cheap in three months."

In the run up that started in March, investors ditched their reliable defensives to chase a sexier, riskier opportunity. But, like a spurned lover, investors will come back to the safety and predictability that defensives offer.

What we like most about defensives right now is that they are cheap. The group trades on an average P/E under ten times next year's earnings. And this represents a 15% discount to the wider market. The last time these stocks were this cheap was in the late 1990s, before they more than doubled! Remember also that most defensives have strong balance sheets, so the risk of expensive rights issues or other nasty shortfall surprises are remote.

Best of all, many Blue Chips are great defences against the threat of inflation

Inflation-beating investments

The big question right now is this, "inflation or deflation?" Either we'll see a 1970s-style monetary expansion causing huge inflation or we'll see a Japanese style zombie-bank-driven deflationary spell.

What leads us to believe inflation will be the eventual winner is the advent of 'quantitative easing'. The £125bn spending program launched by the Bank of England in March has already boosted the UK's monetary base, and continues to do so. This means that there is more money sloshing around in the economy.

When you combine a growing monetary base with shrinking national output you get, quite literally, more money chasing fewer goods and services. This is the very definition of price inflation, according to Nobel prize-winning economist Milton Friedman.

So what should you buy in this environment? Let's take a look

While gold is often seen as the ultimate store of value, it's stocks that have the most consistent track record

Back in 1980, the American Consumer Price Index went up by more than 12%. However, the S&P 500 index climbed 32%. You can see it on a longer time frame, too. Throughout the 1980s, the average rate of inflation was 5.6%. You'd think that that must have hurt investors. And yet, the 80s ended up being superb for stock markets: the S&P returned an average of 12.6% a year.

As mentioned, defensives, more so than small-cap or mid-cap shares, have the most going for them. These companies are sector bullies that dominate their respective industries. They have the power to pass on costs without the threat of losing their customer base.

In order to play this trend, there are four areas of the market to focus on:

Food retailers, telecoms, tobacco and utilities.

In these sectors United Utilities (ticker: UU), Imperial Tobacco (ticker: IMT) and Tesco (ticker: TSCO) all look undervalued and due for a bounce back as inflation joins the bear market as a major headache for UK investors.

This article was written by Theo Casey for The Right Side and was first published on 25 June 2009

Theo Casey is investment director for The Fleet Street Letter. Click here for his new report on why the radical threat of hyper-inflation could hit sooner than you think. It shows you exactly what to do and what stocks, funds and commodities to be holding right now.