3 Defensive Stocks for Turbulent Times

I recently wrote about some large pharmaceutical companies, extolling their virtues for protection against possible market ills. I don't want to be labeled redundant, but there are more stocks in the health-care sector of the Standard & Poor's indexes for your consideration. When your portfolio feels a headache coming on, being invested in defensive stocks will help stop the pain.

These big pharmaceutical companies are set to report earnings within the next two weeks: Pfizer (NYS: PFE) ; Merck (NYS: MRK) ; and Mylan (NAS: MYL) . Pfizer and Merck are also Dow component stocks, which should give added protection. Let's take a look at these stocks for earnings expectations and, more importantly, earnings quality.

The Motley Fool Earnings Quality Score database looks at stocks in the S&P indexes and ranks them "A" through "F" based on price, cash flow, revenue, and relative strength among other things. Stocks with poor earnings quality tend to underperform, so we look for trends that might predict future outcomes.





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Source: Yahoo! Finance.





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Source: Yahoo! Finance.

These tables don't give investors much guidance or confidence how to proceed. While Wall Street analysts use these metrics to make buy, sell, or hold recommendations to their clients, more information is needed to make an informed decision. Let's see if we can spot some trends that may be enlightening.

Pfizer's revenue and earnings are projected to decline this quarter and full-year. Pfizer enjoys high gross, operating, and net profit margins, but they have been trendless over the last two years. The company's rank of "C" is because of mediocre cash management, as accounts receivable as a percentage of revenue is very high at 92%. Inventory has been decreasing, but inventory turns are ridiculous at 227 days -- down from 326 days two years ago. The cash conversion cycle, a measure of cash management efficiency, is also high at 214 days. Over the last 12 months, Pfizer spent $9.23 billion on float reduction, $895 million on acquisitions, $6.29 billion on dividends, and $2.36 billion on debt reduction, but still had $2.56 billion net change in cash. Pfizer's stock has increased 10% since January, and shareholders enjoy a healthy 3.7% dividend ($0.88). The company just announced it won its patent litigation for Lyrica, so it retains revenue on its drug -- worth about $3.7 billion in 2011 -- until 2018. Pfizer is a good defensive play.

Merck, another Dow component, has stable costs and gross margins, but operating and net profit margins have been rising. The operating cash flow margin over the last 12 months has increased also -- a good sign -- and likely the reason behind Merck's "B" earnings quality rating. While under control, receivables have been rising slightly as have days sales outstanding. Inventory levels are down. Over the last 12 months, added debt equals $360 million; $1.71 billion was used to repurchase shares; and $4.8 billion was for dividends, ending with $2.96 billion positive change in cash. Merck's $1.68 dividend equals a 3.8% yield, and the stock has advanced 13.34% this year. Merck's earnings quality score reflects these positive trends. Merck is a solid dividend payer and is worth of a spot in your portfolio for the long term.

Mylan is a large manufacturer of generic drugs, which means it makes and sells generic versions of drugs that have come off patent, among other things. Mylan's cost structure is higher than the branded pharmaceutical companies like Merck or Pfizer, and so its margins by definition are slightly lower. The good news is that revenue is advancing, and earnings are expected to rise nicely for the coming quarter and the full year. And while the gross, operating, and net profit margins are 43%, 18%, and 8%, respectively, all are rising.

Cash management issues seem to be the culprits behind the company's poor earnings quality rank. Operating cash flow margins over the last 12 months are declining, but still a reasonable 10% of revenue. Receivables are 97% of revenue, and the trend is upward, and the dollar value of receivables is rising faster than revenue. Inventory as a percentage of revenue is also high at 93%, and the inventory trend is also rising slightly.

During the last 12 months, Mylan had $561.7 million net income and spent $80.5 million on acquisitions, $2.20 billion to pay down debt, and $291 million on stock repurchases -- with $350 million negative cash change. Since January, Mylan's stock has only increased $0.15 to $22.30, and the company pays no dividend. Its P/E is 17.26, which is slightly lower than earnings growth estimates. The company is still a defensive play, but I'd like to see some trend reversal before making a purchase.

Foolish bottom line
Defensive, high-dividend paying stocks can improve the long term health of your portfolio, and you may get some added appreciation as well. Foolish readers should base investment decisions on earnings quality.

The Dow is loaded with companies with solid dividend payouts and highly sustainable business models built for the long haul. The three stocks in this free report all have an X-factor that makes them stand out from their illustrious Dow peers. Read the report by clicking here right now.

The article 3 Defensive Stocks for Turbulent Times originally appeared on Fool.com.

Fool contributor John Del Vecchio is co-advisor to Motley Fool Alpha and co-manager of the Active Bear ETF (NYS: HDGE) . You may follow him on Twitter @johnfdelvecchio. He does not own any shares in the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Pfizer. The Motley Fool has a disclosure policy.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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