When we look for defensive stocks — that’s to say businesses whose prospects aren’t heavily dependent on the performance of the wider economy — our first port of call tends to be the blue-chip FTSE 100 index.
Companies such as National Grid, British American Tobacco and GlaxoSmithKline are classic defensive picks. And, indeed, are fine core holdings for a portfolio.
However, there are some businesses in the second-tier FTSE 250 that also have excellent defensive credentials. Furthermore, they offer valuable diversification in that they operate in sectors that simply aren’t represented in the top index.
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Market leader
Shares of Dignity (LSE: DTY) have moved higher today after a Q1 trading update this morning. At a price of 2,700p, this provider of funeral-related services has a market cap of £1.35bn.
You won’t find a business in this industry in the FTSE 100. In fact, Dignity is the only company from the sector listed on the London stock exchange. While it isn’t big enough for the top index, it is, nevertheless, the UK’s largest operator. The fact that it’s the market leader — in what is a fragmented industry — adds to the investment appeal in my book.
Performing well
The company today reported “a strong start to the year, with all parts of the business performing well” — these being funeral homes (68% of group revenue), crematoria (22%) and pre-arranged funeral plans (10%).
At the current share price, Dignity trades on a trailing price-to-earnings (P/E) ratio of 22.5. This is only modestly higher than the P/E of 21.2 for the FTSE 250 as a whole and is a premium that I believe could be worth paying for a unique defensive business.
On the face of it, the dividend yield of 0.9% on last year’s payout of 23.59p is distinctly underwhelming. However, historically, the company has delivered hefty additional returns of cash to shareholders from time to time, including a 120p-a-share payout in 2014. I expect such ‘extras’ to continue in future, making the income prospect rather more attractive than implied by the running 0.9% yield on the ordinary dividend.
Two strings to its bow
Water utility Pennon (LSE: PNN) is another FTSE 250 stock that offers defensive diversification outside of the FTSE 100. It’s true there are regulated water businesses in the blue-chip index, in the shape of Severn Trent and (the misnamed) United Utilities, but Pennon offers something that its larger peers don’t possess.
The £3.62bn FTSE 250 company is really two businesses: South West Water and waste management firm Viridor. Admittedly, Viridor is somewhat attuned to the performance of the wider economy (as shown by recent problems with one contract) but the two strings to Pennon’s bow also have advantages.
Worthy of consideration
At a current share price of 870p, Pennon’s running dividend yield of 3.93% compares favourably with United Utilities’ 3.76% and Severn Trent’s 3.33%. Furthermore — and partly due to the earnings contribution expected from Viridor — Pennon’s dividend policy is to increase the annual payout by 4% above RPI inflation through to 2020. United Utilities and Severn Trent are only offering increases that at least match inflation over the same period.
I wouldn’t necessarily shun the blue-chip pair, but Pennon appears worthy of consideration on account of its attractive dividend prospects and a not-unreasonable trailing P/E of 21.8.
