Five Defensive Plays for an Uncertain Market

	Paul Tracy Street Authority.com
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Investing is never easy, but for most of the 1990s investors could have been forgiven for believing it was a sure road to riches. From 1990 through 1999, for example, the S&P 500 returned an average of +18.2% on an annualized basis. Meanwhile, the tech-heavy Nasdaq Composite fared even better, handing investors an average annual gain in excess of +24.4%. All of this prosperity came courtesy of the longest uninterrupted bull market in U.S. stock market history.

That stellar performance led to the widespread belief that any investor holding a diversified basket of blue-chip companies could expect to earn solid double-digit returns year after year. In fact, a survey conducted in early 1999 by the Institute of Psychology and Markets found that the average mutual fund investor was expecting just that--annual returns from mutual funds of nearly +19% over the long term. And despite the severe market correction of 2000—2002, optimism dies hard; a similar study in late 2001 conducted by the same organization found that over +40% of investors still expected a gain of between 10% and 20% for 2002.

If market history is any guide, then such lofty expectations usually end in severe disappointment. The truth is that the 1990s and, in fact, the entire bull market of 1982 through 2000, was a very unusual period in market history. Looking back over the past century and a half of U.S. stock market data, we can say with confidence that returns over the recent 18-year bull market were far above average.

But what exactly is this "average" return?

Estimates for this vary wildly and it depends on what time period you're studying. However, British economist Andrew Smithers of Smithers & Co. has studied long-term stock market returns in several countries using rolling return calculations--he looks at returns in rolling 15 and 30-year periods. He calculates the very long-term average return at between 6.5% and 7%. That's roughly half the return investors witnessed in the 1980s and 1990s.

It's also important to note that the market tends to move in broad cycles--long bull markets are usually followed by several years of modest or below-average market returns. The bottom line: investors should not expect to see returns out of stocks over the next 5 to 10 years of the same magnitude we've enjoyed over the past 20.

Back to the 1970s

Check out our bar chart below. In depicts annualized returns for the S&P 500 and Dow Industrials over different periods in market history. Note that while returns in the 1980s and 1990s were undoubtedly impressive, the S&P 500 has seen long stretches of near-zero or even negative returns.

Take the 15-year period from 1965 to 1980 as an example. This long period can best be described as a trading range; the S&P 500 certainly saw some large swings but, taken as a whole, stocks more or less marched in place, offering annualized gains of less than +4.5%.

And, in fact, this period bears some major resemblance to the current market. Just as now, in 1965 the U.S. averages were just finishing an impressive multi-year bull market. The bull market of 1950 through 1965 offered returns that were certainly respectable and above average, if not as impressive as the more recent late 1990s bull run. The 15-year period from 1965 to 1980 acted as a breather in the wake of that run-up. And back then, as now, the world faced multiple political and economic challenges; geopolitical tensions, rising oil prices and the specter of inflation certainly rank near the top of the list for both periods.

If the market follows the same path as it did after 1965, it certainly seems plausible that we're in for a prolonged period of flat or below-average returns from the broader averages. This would characterize a sort of rest stop from the blistering bull run of the 1980s and 1990s.

And remember, this is not just some isolated period that we've cherry-picked from the available data. History is replete with examples of tremendous bull markets followed by years or even decades of sub-par returns. Academics call this phenomenon "mean reversion." Simply put, the market over a long period of time tends to revert to an "average" or "mean" rate of return. Periods of extremely high returns tend to be followed by below-average performance, and over the long run these peaks and valleys tend to cancel each other out.

Another oft-cited example is Japan's Nikkei 225 in the 1970s and 1980s. Japan posted tremendous economic growth over this period. In the process, the country gained a reputation as a manufacturing powerhouse and companies like Toyota, Hitachi and Sony began to emerge as globally dominant players in their respective industries. Some even began to refer to Japan as an "economic miracle" given its rise from near total economic destruction in the wake of World War II. It's hardly surprising, then, that the Nikkei 225 posted an impressive run-up up until 1990.

But let's not forget what happened in 1990--the Nikkei, like the Nasdaq Composite a decade later, saw a vicious bear market from 1990 through 1993. Even more importantly, after that crash, the Nikkei didn't turn suddenly and make another run at its old highs. Instead, the Nikkei has spent the past decade or so roughly trading sideways.

We won't bore you with a list of similar periods and other examples. Suffice it to say that no matter what country you care to study, you'll find plenty of dramatic boom-bust cycles. And, more importantly, you'll find plenty of periods 5, 10, or even 20 years in length where the returns delivered by stocks were far below the +7% average.

Market Headwinds

Apart from broad economic and market cycles there are also other reasons to be wary. My staff and I have highlighted several such concerns over the past few months in our Market Commentary section. Take for example, the recent surge in oil prices.

Crude oil is, in many ways, the lifeblood of the global economy. Although the U.S. and Europe have become more energy-efficient over the years, cars and airplanes still run on petroleum-based products. In addition, oil can be found in some pretty surprising places. Plastics, many household chemicals and even the coating on most pharmaceutical pills contain oil-based compounds.

This tremendous dependence on crude oil makes the recent surge in oil prices to multi-decade highs all the more concerning. Higher oil prices push up the costs of all sorts of derivative products, taking money directly out of consumers' pockets.

We've also been careful to highlight increased terror risks in a post-9/11 world. Businesses are spending on increased security, insurance and employee safety. These expenses, while necessary, sap capital from other investing activities.

Back in the 1970s and 1980s it was the often-fragile relationship between the former U.S.S.R. and the U.S.A that provided most of the geopolitical tension. Nowadays, the threat of terrorism is the culprit. Either way, however, the global economy isn't enjoying the same peace dividend that prevailed for throughout most of the 1990s.

How to Play It

As investors, how should we react to this uncertain environment? While there are certainly causes for concern on a macro level, burying your head in the sand and waiting for the clouds to part is never a winning investment philosophy.

The truth is that no matter which direction the overall market heads, there will always be plenty of stocks and sectors in strong bull markets. During the 1970s, for example, as we outlined above, the S&P 500 returned around 5% annually. However, an investment in a diversified mix of oil stocks over that same time period could have managed a return of more than double that. In addition, plenty of solid, well-managed defensive stocks like Coca-Cola (KO) managed to produce double-digit annualized returns over that decade.

As my staff and I outlined in last month's special report on Warren Buffett, there are always solid investment opportunities out there, even in flat markets. The Oracle of Omaha managed to deliver attractive returns even in the choppy markets of the late 1960s and throughout the 1970s. In fact, Buffett posted some of his best annual returns during this unremarkable period of U.S. market history.

With this in mind, my staff and I recently went on a search for companies with solid, defensive businesses that could weather a sluggish market environment. However, there's a difference between defensive and low-growth. While investors may flock to companies in stagnant but steady businesses when the market gets really tough, that's usually a temporary phenomenon. Over the long haul, companies that show solid, sustainable growth will always outperform the rest of the market.

In the process of our search we discarded companies in staid, low-growth markets and focused on growing companies with wide economic moats--companies not overly leveraged to an economic pullback or open to major new competitive threats. In addition, my staff and I also looked for a major growth catalyst for each firm. In other words, we searched for some sort of long-term positive fundamental change or development that's likely to spur future growth.

Here's a closer look at a few of our favorite defensive plays for the coming years:

Iron Mountain (IRM, $31.80)

Remember all the talk of the so-called "paperless" office back in the 1980s? The idea was that new, improved technologies for electronically storing and publishing data would make paper, printers and photocopiers obsolete by the turn of the century. That never came to pass. In fact, businesses have become even more paper-dependant since the dawn of the Computer Age.

The fact is that faster laser printers make printing documents ever easier and photocopiers make it a simple matter to reproduce and distribute copies of important documents. This has led to an explosion in paper: U.S. government estimates put the paper consumption of U.S. businesses at 850 billion pages in 1981, 2.5 trillion by 1986 and a whopping 4 trillion by 1990. The widespread introduction of PCs by the latter half of the 1980s clearly did nothing to stem the flood of paper at American businesses.

This trend has also accelerated since the passage of the Sarbanes-Oxley Act back in 2002. This law, enacted in response to a series of corporate accounting scandals, requires companies to hold onto more of their accounting paperwork and intra-office memos. This act of Congress also mandates that CEOs sign off on the accuracy of their accounting statements and be held personally responsible if inaccuracies are brought to light. The result: CEOs need to have plenty of documentation to back up their certifications.

All these reams of paper tend to pile up over time, leading to serious storage problems for many firms. While some smaller businesses may be able to house all of their important documents on-site, most companies need to look for alternatives. What's more, effectively organizing large files full of paper for easy retrieval is a difficult and time-consuming task, even in a relatively small office. That's where the world's leading document storage company, Iron Mountain, comes in.

The firm owns and operates about 800 document storage facilities scattered throughout the U.S., Canada and Europe. Each consists of a sizable warehouse on a large plot of land. Businesses store documents in these warehouses for a fixed monthly fee. In addition, they pay supplemental fees for other services like document retrieval, copying or destruction.

For most companies, document storage isn't a very economically sensitive business expense. Laws such as Sarbanes Oxley simply require firms to store paper documents. And, despite an economic downturn in 2001 and 2002, recent figures released by the paper industry showed only a modest reduction in paper demand.

And on the competitive front, Iron Mountain's global dominance is a major tailwind. The company has already captured two-thirds of the U.S. market for paper storage and half the global market. It's rather expensive for companies to switch storage companies--there's a prohibitive fee for removing, transporting and re-organizing documents. As a result, Iron Mountain's customer base is locked-in to its services, giving the firm an extremely wide economic moat.

On the financial front, company revenues have been growing at a 20-25% clip in recent quarters. However, if we strip out the revenue gains from acquisitions, growth shrinks to around +8%. At first blush that may make the company's 30-plus forward P/E multiple seem a little rich.

However, Iron Mountain has been very successful in selling higher margin services like document shredding to its existing customer base, boosting overall profit margins. That's helped keep earnings growing much faster than organic revenues, at around +15% in the most recent quarter. In addition, we'd expect to see a dominant player like Iron Mountain in a recession-resistant industry trade at a premium valuation. Given the company's solid financial performance and wide economic moat, the stock appears to be well worth the price.

Central European Distribution Corp. (CEDC, $23.70)

If there's one product that just about any bar, restaurant, nightclub or convenience store needs to sell to be profitable, it's alcohol. In the U.S., liquor distribution is a highly competitive but stable business that offers decent cash flows, but it's hardly a major growth market. Not so in Eastern Europe: in the rapidly emerging economies of the former Soviet Bloc, demand for all sorts of alcoholic beverages is growing steadily. And best of all, there's not much competition in the alcohol distribution market.

That's where CEDC fits in. The company is Poland's largest importer and distributor of alcoholic beverages, including beer, wine and spirits. In total, the company distributes these products to about 31,000 different Polish businesses of all sizes.

In 1997 when the company started operations, liquor distribution in Poland was controlled by a patchwork quilt of small mom-and-pop operations. In addition, the main supplier of domestic liquors was the Polish government itself, a legacy of the centrally planned communist era. As you might suspect, that was an extraordinarily inefficient way to do business. Government run distillers were encumbered by excessive bureaucracy and poor management. And costs for the distributors were high because none had the scale to negotiate favorable contracts with foreign or domestic suppliers.

But CEDC changed all that, garnering $12 million in funding from Wall Street and buying Poland's liquor distributors one by one. In each case, CEDC left in place some of the existing management team to help maintain local market knowledge. As a result of its aggressive acquisition spree, the company's growth has been impressive. Over the past five years CEDC has posted annual revenue growth close to +50%. Meanwhile, profit margins have risen in the process, leading to earnings that have grown even faster than revenues.

CEDC has done a great deal to consolidate the Polish distribution business, buying up smaller competitors consistently since it opened up shop in 1997. But despite the firm's progress over the past few years, the Polish distribution business is still a highly fractured market. As a result, CEDC still has plenty of promising opportunities on the acquisition front. Last year, the company made a total of three acquisitions. At the beginning of 2004 management targeted four other companies for acquisition and has already completed two of these purchases so far this year. Most of the company's purchases have been immediately accretive to earnings. In its most recent purchase, for example, CEDC picked up a small distributor for $2.5 million, and subsequently boosted its earnings guidance for the rest of 2004 as a result.

These results are impressive, but CEDC's new avenues of organic growth appear even more promising. In the past, the company has primarily operated as a distributor of domestically produced spirits. Right now that business accounts for just under 70% of the firm's revenue stream. However, in recent quarters, CEDC has also moved aggressively to become the dominant distributor of imported spirits.

Prior to May 1st, all of these imported brands had been subject to import tariffs. However, with Poland's recent accession to the European Union (EU), all such tariffs have now been permanently removed. The result: CEDC drastically cut prices and saw a +40% jump in sales. Because of this, the company's high-margin imported liquor business is set to garner a larger slice of the revenue pie. That's one reason the company recently raised guidance for the full year.

In addition, CEDC is exploring the distilling business as a new avenue of growth. Until recently, most distilleries in the country had been government owned. However, as part of the nation's privatization program--spurred by EU reform--most are in the process of privatization. CEDC recently received approval from the government to bid for Palmos Bialystok, the nation's largest such distiller. Given that Polish vodka brands are showing rising popularity outside Poland, we expect CEDC to develop a liquor export business over the next few years.

Trading at less than 16X forward earnings and with almost no debt, CEDC looks poised to continue its recent winning streak thanks in large part to the recent EU expansion.

Carmax (KMX, $20.71)

The used-car business doesn't exactly enjoy a great reputation with consumers. Unless you're a mechanic, it's hard to judge just how many expensive problems you're inheriting when you buy a used vehicle. And then there's price--few cherish the thought of extensive negotiations over price.

This negative sentiment actually spells opportunity for quality retailers like Carmax. The company, which operates the nation's largest chain of used-car superstores, attempts to make used car buying a more enjoyable experience. It does so by offering no-haggle pricing, comprehensive vehicle inspections and financing for buyers. Even better, by focusing primarily on used cars, Carmax offers a much broader selection than you'd find at a typical dealer--the firm sells all vehicle makes and models.

The used-car business is also far more recession-resistant than that of new car sales. In recent quarters, for example, new car sales have been disappointing, particularly for American manufacturers like General Motors (GM, $42.68). General Motors dealers have had trouble selling model year 2004 cars and an inventory of almost a million vehicles are now sitting on the lots at the nation's dealerships. Some of the largest publicly traded new car dealers, such as Group 1 Automotive (GPI, $27.98), are actually cutting their orders for 2005 vehicles because they're having trouble getting rid of the 2004s.

GM has responded to this slowdown by cutting prices and offering a variety of factory incentives like zero percent financing. Because the cost of manufacturing a car remains fixed, this is bad news for GM--lower prices spell lower profits.

However, the story is completely different when it comes to the used car market. Used car dealers buy directly from consumers. When incentives on new cars rise, that depresses the price for equivalent previous models of used cars. So, for example, as GM cuts prices, Carmax will have to pay consumers less to buy their used cars. Of course, Carmax will also have to reduce its selling prices but that's not such a big deal: the company's buying and selling prices go down in tandem, preserving profitability.

Although Carmax has quickly grown into a $2 billion company, it's still a small fish in the used car business. By most estimates the firm's market share remains less than 1% nationwide. That leaves plenty of room for growth as the company rolls out new dealerships and continues to expand across the country via acquisitions.

Financially, it's difficult to find a company in better shape than Carmax. The firm's debt stands at only 17% of shareholder's equity and half of that is covered by cash on the books. The negative headlines swirling around recent troubles in the new car market have unfairly helped to depress Carmax's share price. As a result, the stock has dropped from $40 to $20 over the past year. That's great news for new investors, as KMX now trades at only 17X forward earnings. With growth running at around +20% per year and years of solid expansion ahead of it, the stock now looks like a great bargain.

Ceradyne (CRDN, $43.54)

With a market capitalization of just $700 million, Ceradyne is a small-cap stock. But don't let the company's size fool you into thinking it's a second-rate player; the company is a key supplier of ceramic body armor and missile components to the U.S. government.

The company derives about 60% of annual revenues from its defense business. Military spending on ceramics fits into two broad categories: armor and missile cones. Both markets have seen rapid growth, particularly since the September 11th terrorist attacks. In fact, growth has been so rapid that Ceradyne has needed to add to its manufacturing capacity just to keep up with demand.

Ceramic body armor is the more important military market for Ceradyne right now. In urban warfare settings, troops are constantly exposed to enemy fire--one of the only lines of defense is body armor. Clearly, body armor has become an absolutely crucial piece of equipment for troops stationed in both Iraq and Afghanistan.

In fact, in late August the company won a 3-year $461 million contract from the government for such armor. That contract alone represents more than half the stock's total market capitalization. And even before that deal was inked, Ceradyne was already facing a backlog of well over $100 million in orders. As a result, we expect the company's two new manufacturing facilities to be running at full capacity through at least 2006.

The second major defense application for ceramics is in missile nose cones. Modern-day missiles carry a great deal of sophisticated electronic equipment used to locate targets, communicate with headquarters and keep tabs on current positions. Most of this equipment requires the transmission of some sort of electronic signal, most commonly either radar or microwave transmissions. As such, it's critical that such signals be able to pass freely through the missile's nose cone.

Ceramics are the ideal choice for these applications. You might remember that ceramic tiles are used on the Space Shuttle to protect it as it re-enters Earth's atmosphere; ceramic is very good at controlling heat. And unlike some metals, advanced ceramic materials don't offer much interference to electronic signals. Ceradyne is a major supplier to the military, as the firm manufactures nose cones for the advanced Patriot "Pac-3" anti-missile system. These missiles are now being widely deployed both to protect U.S. troops in Iraq and Afghanistan, as well as in nations like Japan, which is concerned about the North Korean missile threat.

My staff and I were also encouraged by the company's decision to purchase Germany's ESK Group, a supplier of boron carbon powder. This particular powder is an important base material in the manufacture of ceramic armor. With high-strength ceramics in such high demand worldwide, supplies of the powder can get tight quickly. The ESK acquisition has enabled Ceradyne to nail down a reliable supply of this key material.

Ceradyne is the quintessential defensive growth company. Military spending is not sensitive to economic fluctuations, and with so many geopolitical hotspots around the world, you can expect plenty of demand for defense-related products in the coming years. Ceradyne's estimated growth over the next five years is on the order of +20%, although new contract wins could offer upside on that figure. Trading at about 20X forward earnings, the stock still looks like a bargain.

Valero Energy (VLO, $68.69)

Valero Energy is one of the nation's largest petroleum refiners, boasting a total capacity of about 2.4 million barrels per day from its 15 refineries in the United States. On top of that, the company has a small marketing operation that includes about 4,500 service stations across the U.S. and Canada.

You can't power your car with crude oil. First, oil has to be broken down and purified to form a host of useful products like gasoline, kerosene, and jet fuel. This is the crucial step performed by refiners like Valero.

And the refining business is becoming ever more profitable. Due to a host of environmental regulations no new refineries have been built in the United States since 1976. Even worse, new regulations often make older refineries obsolete. As a result, some capacity is actually destroyed over time.

At the same time, demand for gasoline has been rising steadily. There are more than triple the number of cars on the road now than there were in 1976. And outside the U.S., growth in demand has been even more impressive--China and India, in particular, have seen record automobile sales over the past few years. A decade ago, these countries actually had spare refining capacity and could export refined gasoline. However, both nations are now barely able to keep up with domestic demand.

Rising demand and a fixed supply has led to record profits for oil refiners in recent years. That puts Valero, one of the nation's largest and most efficient refiners, in the catbird's seat. The company has been buying up its smaller, less efficient competitors and is running at near-full capacity just to keep up with demand.

Even better, as we explained in our May 24th Market Advisor issue, all crude oils are not created equal. The crude oil prices we hear quoted every evening on the business news are normally for benchmark "sweet" crudes. Sweet oils are among the purest grades of crude in the world. Other types, known as "heavy sour crudes," require extra refining steps to meet sulphur pollution regulations. These grades of crude routinely trade at a $10 to $12 discount to sweet crude.

Remember that refiners make money by purchasing crude oil and converting it into refined products like gasoline. Therefore, these companies earn money on the relative prices of crude and gasoline; high crude prices alone do not help the refining business. The good news for investors is that Valero has significantly improved on its profit spread by processing a growing percentage of cheaper "heavy sour" crudes in recent quarters.

The company is able to sell gasoline processed from heavy crude at the normal market rate because gas is the same whether it's made from sweet or sour crude. With this in mind, Valero has boosted its profit margins because it is able to pay far less for sour crude.

In the second quarter of this year nearly 70% of the company's feedstock was heavy sour crude, up significantly over levels seen last year. Only large refiners like Valero are able to effectively refine this type of oil. Older, less advanced refineries have to opt for more expensive light sweet crude. Even worse, most firms in Asia do not have the capacity to refine sour crude, so refineries there tend to bid up global prices for sweet varieties.

With the supply/demand balance now heavily in their favor, large refiners like Valero should continue to post consistent financial results for years to come. It takes years to get approval to build a new refining operation. And given the strong demand for gasoline and other petroleum products around the world, existing refiners should continue to run at near-full capacity for the foreseeable future. Trading at less than 9X earnings and growing at least +10% annually, Valero is a great play on the booming global energy market.

Paul Tracy will be available to take your questions until Thursday, September 23. Please use the form below to submit your questions.