While most investors are celebrating as the FTSE 100 reaches record highs, the contrarians among us are already girding themselves for the inevitable downswing. With valuations across the index looking stretched and domestic economic data weak, moving to protect your downside is looking more important than ever.
A management team worth its salt
That’s why I have my eye on two defensives that produce reliable income no matter the economic environment. The first is long-time investor darling Reckitt Benckiser (LSE: RB). Shares of the consumer goods giant have doubled in the past five years for good reason and there’s little to suggest they can’t do so again in the next five years.
Aside from steady top-line growth, 2% year-on-year in 2016 at constant exchange rates but 11% at actual rates, the company’s management team has long prided itself on its laser-like focus on continually improving profitability. This led to operating margins reaching a stunning 24.3% in 2016, nearly double those of competitors such as Unilever. This is filtering through to investors as earnings per share for the year rose 6% to 256.5p.
Rising earnings comfortably covered the company’s 153.2p annual dividend even as the latter rose 10% year-on-year. With cover this high and an incredibly cash generative business (free cash flow was £2bn in 2016), there’s plenty of room for the board to continue its long track record of increasing shareholder returns.
One potential pitfall investors should be aware of is the company’s $18bn bid for infant formula maker Mead Johnson. While RB’s core focus is consumer health products, this deal would dramatically increase the proportion of its sales coming from relatively lower margin, lower growth foodstuffs. The company has a long history of successfully pulling off acquisitions but investors will need to watch closely for signs of stumbles.
But if the deal goes as planned, like many have before, the combination of higher exposure to fast growing emerging markets and steady, non-cyclical sales from core brands could make RB shares a bargain even at 21 times forward earnings.
The big benefits of an addictive product
Another top FTSE 100 defensive that could be on the other end of mega M&A deals is Imperial Brands (LSE: IMB). This is because the company is a relative minnow in the world of globe-spanning tobacco companies with a market cap of just £36bn.
And potential suitors have plenty of reason to take a bite out of the company as it controls 9.2% of the American market, the world’s most profitable tobacco market outside of China.
But even if an larger competitor doesn’t swoop in on Imperial, I reckon owning its shares still make a great deal of sense for more risk-averse investors. While the developed market-centric company isn’t growing organically, it is constantly improving free cash flow by cutting costs, focusing on a few core brands and making small bolt-on acquisitions.
Last year the company increased net cash from operations from £2.7bn to £3.1bn, which allowed it to increase dividends by 10% while maintaining a very manageable payout ratio of 62%. Shareholders now enjoy a 4% yielding dividend that is safely covered and growing sustainably as earnings rise.
Imperial’s shares trade at just 14 times forward earnings, a significant discount to higher growth peers. But with a 4% yielding dividend, stable revenue and the ever-present potential for a big buyout, this tobacco giant is one I’d be happy to own.
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Ian Pierce has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Unilever. The Motley Fool UK has recommended Imperial Brands and Reckitt Benckiser. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.