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Two defensive plays for dark days

Recent market action has reminded Charlie Gibson of Black Monday - and the value of defensive investing. Here he picks two stocks that will see you through tough times.

Recent market action has reminded me of Black Monday. A trainee stockbroker at Buckmaster & Moore in 1987, I remember the fear and elation gripping the market that morning as the FTSE 100 dived 400 points. We had seen a huge bull market since 1980 and there was a sense that something had to give. Still, a 20% fall was so huge that my first thought was that someone had miscalculated. Back then, 20 points was a large move, and 40 would generate headlines. Four hundred was unimaginable like waking up tomorrow and finding the market down 1,200 points. But it was also the first time I realised the benefits of a good defensive stock.

Amid the sea of red, just one FTSE 100 firm was etched in blue: Associated British Foods (ABF). While what we have seen recently is nothing compared to 1987, when I saw the FTSE 100 down 267 one morning and ABF up 2.2%, I couldn't help but recall that experience.

ABF is still a good defensive play

Plus a change, you might say. But quite a lot has changed. Until 2000, ABF was dominated by British Sugar, turning sugar beet into Silver Spoon sugar, while its Primark retail chain accounted for about a third of the business. But in the last seven years, ABF has been transformed, buying brands such as Ovaltine and Littlewoods. Yet it still has solid defensive qualities. Almost 80% of revenues come from primary food and agriculture, groceries (including Silver Spoon sugar and Kingsmill bread) and ingredients (ie, yeast), with the rest derived from retail.

As a result, its latest trading update was rather mixed. It benefited from falling energy costs, price rises at its Australian baking and milling business, rising yeast sales, and substantially higher Primark sales. But it was also hit by volatile commodity prices, the strong pound, high raw-material prices in its enzymes business, a competitive bread market and falling retail sugar prices in the UK.

But while such a mix tends to limit growth, it doesn't negate it; management can add value through sound strategic decisions. ABF's acquisition of South Africa's Illovo sugar is a good example. Rather than face a slow decline after changes to the EU sugar regime, the purchase of Illovo shifted ABF's sugar production down the cost-curve, giving it room to manoeuvre in a changing market. ABF then found new uses for its sugar beet unit, resulting in it building the UK's first significant bioethanol plant.

These initiatives (including the purchase of Littlewoods' stores) are likely to hold back short-term adjusted earnings growth as acquisition costs are borne before benefits are reaped. But the end is in sight. Management expects adjusted earnings to rise in the year to September, although this will be "weighted towards the second half". Beyond that, ABF is well placed. The City now expects adjusted earnings per share to grow about 4% in the year to September 2007 and 10% the year after. My model suggests a sell limit for ABF of 953p and a buy limit of 833p.

Half-year results are likely to be unspectacular, so there is scope for short-term weakness in ABF's share price. But if things take shape as both the City and management seem to expect, then I am confident that investors will look back at this point as a good buying opportunity.

Is Reckitt too expensive?

The problem with thematic investing is that it takes little regard of price. Everyone takes fright at global imbalances, for example, and piles into defensive sectors; but they tend to buy the same stocks, pushing prices up. The underlying stock is still defensive', but its price becomes anything but. Take Reckitt Benckiser (RB). It has been a spectacular performer in the past six years and its products are household names cleaning materials such as Finish and Calgon, and medicines from Disprin to Lemsip.

Between 2001 and 2007, earnings growth was regularly in the high teens. The market rewarded the firm with a historic p/e of between 21 and 29. Last year was another great year, with diluted adjusted earnings per share up 19%. But I wonder if things aren't slowing down a bit. Full-year revenue was up 18%, but excluding the acquisition of Boots Healthcare International, it was a more modest 6%. And despite a flurry of new products, Reckitt's management seems keen to moderate expectations, talking of revenue targets of "at least 6%" and net income growth, at constant exchange rates, "in the low double digits". The City has taken this to mean compound growth in diluted adjusted earnings per share of 11% over the next two years. That's respectable. What's more surprising is to find Reckitt's shares apparently accelerating higher.

It's possible to make a case for Reckitt's shares being worth around £28-£29. That's about 10% above current levels. But over that? There's an old City saying about leaving the last 10% for the market'. After such a good run in the past six years, I'd suggest investors do just that and book a few profits. I'd look at buying again if the price falls below £22.66.

Charlie Gibson is an analyst and a private investor

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