A Refresher on Defensive Investing

 | Jun 25, 2014 | 6:00 PM EDT
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With the announcements this 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 way of 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.

Wal-Mart (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.

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