2 Defensive Stocks That Could Offer Traders Double-Digit Returns by 2014

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Defensive stocks are always popular among conservative investors. These are stocks that are believed to have some degree of immunity to the business cycle. Consumer staples are favorites of defensive investors because consumers will always need the products sold by companies like Procter & Gamble (PG). Utility stocks are also considered defensive stocks because there is a constant demand for electricity and gas for heating homes.

Over the past three years, defensive stocks have done very well. SPDR S&P 500 (SPY) is a benchmark for the market and has an average annual gain of 13.36%. Utilities Select Sector SPDR (XLU) did almost as well with an average gain of 13.24% a year. Consumer Staples Select Sector SPDR (XLP) outperformed the broad market and gained an average of 15.39% per year.

The chart below shows that defensive stocks actually have a mixed record in bear markets. These two ETFs lost less than SPY in the 2008-2009 bear market, but they lost more in the bear market that began in 2000.

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SPY vs XLU vs XLP

Defensive stocks are likely to move in the same direction as the broad market in the future, just like they have in the past. After three years of large gains, it seems safe to assume that the next three years will not be as rewarding. Over the long term, stocks have delivered an average annual return of about 10% a year. To get back to average, stocks would need to see gains of about 6.6% a year in the next three years.

Of course, we don't know if stocks will deliver average gains over the next few years. They could do significantly better or worse. But we do know that defensive investors should not count on above-average returns and they should not expect to avoid losses in a bear market.

Given the possibility of a low-return environment, defensive investors should consider a conservative, covered call writing strategy that could help them increase income and reduce the risk of losses associated with positions they intend to hold for the long term.

When you sell a call option on a stock that you own, you are receiving immediate income and creating an obligation to deliver 100 shares of the stock at a predetermined price until the expiration date of the option. Since you already own the stock, your risk is limited. You should only write calls with exercise prices above the current market price. If the stock rises, you profit up to the exercise price. If the price falls, your loss is reduced by the income received for the option.

Because the ETFs have low volatility, this strategy works better with individual stocks. Volatility is a factor in determining options prices and low volatility means a low-priced option. Higher-priced options will generate more income.

Duke Energy (DUK) is the largest holding of XLU. The stock pays a quarterly dividend of $0.765 a share. If you bought 100 shares of DUK at the recent price of $72, you could sell a $75 call on those shares expiring in January 2014 for about $1.25.

If DUK is above $75 when the option expires, you would have to sell the stock at $75 and accept your gain of $3 per share. Your gain would also include the income of $1.25 per share on the option you sold and three dividend payments totaling $2.29 if DUK maintains its current dividend. All together, that would be a gain of $6.54 a share, or 9% in nine months. If DUK falls, your loss is offset by the $1.25 per share in options income.

PG is the largest holding of XLP and the math is similar:

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PG

Potential profits if PG is above $85 when the call expires totals $9.55 (12%). This results from three dividend payments ($1.68), capital gains ($7) and the options income ($0.87). If PG falls, the loss is offset by the options income.

This strategy can work with almost any stock. ETFs will generally have lower options prices because they are diversified and have lower volatility than their individual holdings. Stock prices could rise or fall, but after an extended bull market, upside could be limited and covered calls could help reduce the losses of a potential bear market.

Consider covered calls for long-term holdings, especially for defensive stocks in your portfolio. Many defensive stocks suffered big losses in the last bear market and options income could help reduce losses in the next bear market.

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