Finding the Next Bargain Stock

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A lot can happen in a year. From Nov. 15, 2010, to Nov. 15, 2011, the S&P 500 managed to climb 5%. However, the yearlong journey has been a wild one for Mr. Market. The time period started with a rally from under 1,200 last November to over 1,350 in both May and July of this year, only to stumble badly thereafter.

What happened? Well, quite a lot, it turns out. In just the three-month span from August to October, Standard & Poor's downgraded the credit rating of the United States, eurozone leaders held emergency meetings and summits to try to save the euro, the Occupy Wall Street movement gained steam across the world, and investment bank MF Global filed for bankruptcy after its big bets on European sovereign debt failed.

These developments have caused a steep drop from the market's earlier July levels and have brought about increased volatility. When prospects get dicey, one of the ways to protect one's portfolio is to lean more toward defensive stocks concentrated in sectors such as utilities, health-care, telecommunications, and consumer staples. I decided to look at how some cyclical stocks and defensive stocks have performed relative to each other over the past year.

Looking at the table below, we see that some companies have held up better than others:

Ford (NYS: F) Consumer Discretionary$59 billion$41.3 billion(30%)0.0%
Rio Tinto (NYS: RIO) Materials$84.9 billion$65.2 billion(23%)2.2%
U.S. Steel (NYS: X) Materials$6.7 billion$3.9 billion(42%)0.8%
Duke Energy (NYS: DUK) Utilities$23.5 billion$27.6 billion17%4.8%
Exelon (NYS: EXC) Utilities$26.6 billion$29.4 billion11%4.7%
Johnson & Johnson (NYS: JNJ) Health-Care$176.1 billion$177.5 billion1%3.5%
Coca-Cola (NYS: KO) Consumer Staples$146.2 billion$154.4 billion6%2.8%

Source: S&P Capital IQ.

The table above has one major, overarching theme: The defensive stocks have outperformed the cyclicals. Looking at the more defensive names first, megacap stalwarts Coca-Cola and Johnson & Johnson have eked out positive gains for the past year. The utilities have shined brightly in the past year. Duke Energy and Exelon gained 17% and 11%, respectively, over the past year.

With very stable demand and regular rate increases, utilities are among the most defensive of investments. Many other utilities not in the above table have notched double-digit gains over the past year as well: Consolidated Edison, Dominion Resources, and Southern Co. have increased 17% to 20%.

Turning over to the cyclicals, it's not terribly shocking to see these stocks down given the scary macroeconomic backdrop. Over the past year, Ford, Rio Tinto, and U.S. Steel are all down substantially over the past year. Not all of these types of companies are down over the past year -- Caterpillar is actually up 21% -- but this has generally been true as investors have shunned riskier names in favor of defensive ones.

So what does this all mean? It's nice to play portfolio defense, but I'm not too keen on buying into companies such as utilities that have already increased 10% to 20%. Some of these may still be decent buys, but I'm in the hunt for stocks that have gone down, not up. Given the ongoing scary situation in Europe and the possibility of a Chinese slowdown, I see more volatility ahead. Amid bouts of euphoria and panic, I predict buying opportunities for the patient investor with dry powder ready to go.

Foolish bottom line
With increased volatility likely on the way, I'll be on the lookout to scoop up beaten-down companies at the right prices. They don't have to be cyclicals, but I predict there will be more bargains in that space since they are dumped first in times of trouble. Investors are already scared of them at the moment, and each rushed sale drives these companies further into bargain territory.

If more defensive stocks are what you're after, check out The Motley Fool's new free report "Secure Your Future With 11 Rock-Solid Dividend Stocks." Just click here to get started.

At the time this article was published Paul owns shares of Coca-Cola. The Motley Fool owns shares of Coca-Cola, Ford Motor, and Johnson & Johnson.Motley Fool newsletter serviceshave recommended buying shares of Ford Motor, Southern, Dominion Resources, Coca-Cola, Exelon, and Johnson & Johnson.Motley Fool newsletter serviceshave recommended creating a diagonal call position in Johnson & Johnson.Motley Fool newsletter serviceshave recommended creating a write covered strangle position in Exelon. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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