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What if Dr Doom is right?

Perennial doomsayer Nouriel Roubini (known as Dr Doom) has poured cold water on hopes of a faster US recovery, suggesting US growth is likely to remain, below-trend at best for many years to come.

Former Federal Reserve Chairman Paul Volcker has also suggested that the individual states in the US cannot continue their current spending, taxation and budget practices, and the US federal government’s attempts to reduce its deficit could wreak havoc on the individual state budgets.

Getting back to Roubini — in an article published in the Australian Financial Review, he suggested that the US Federal Reserve will carry out more quantitative easing this year, but it will have little effect, as long term official interest rates are already low – lowering them further will not boost spending.

He also identified that weak demand is having an effect on US companies already, with lower revenues hurting margins and profitability. “A significant equity price correction could be the force that in 2013 tips the US economy into outright contraction”.

The consequences of the US going backwards has severe implications for the rest of the world and indeed Australia. With Europe still trying to muddle its way through bank debt and sovereign economic issues, China slowing down and the potential for the slowdown to accelerate, Australia could potentially face massive headwinds.

So what should investors do?

If the experts are right, now is probably not the time for speculative resource stocks or overpriced growth companies. Instead investors might want to consider a switch to defensive businesses.

By definition, defensive companies are those that have limited external factors driving their business, selling products and services that we can’t do without, such as food, petrol, clothing, healthcare, housing and utilities .These types of  companies generally perform better during downturns.

Ideally these would be companies with low levels of debt or even better, net cash on their balance sheets, strong profit margins – which allow them to see falling revenues, but still produce a profit, and we want some benefit to offset potential falling share prices, in the form of dividends.

They should also be fairly immune to global economic conditions, which would put the focus mainly on companies with no offshore operations. There are exceptions which I’ll come to shortly.

The first and most easily identifiable defensive stocks are Woolworths Limited (ASX: WOW) and Wesfarmers Limited (ASX: WES). Both companies operate supermarkets and petrol stations, selling those essential items we need. They also own and operate hundreds of hotels, liquor outlets and poker machines, which tend to do very well during tough times.

While the dividend yields of both are less than 5% currently, should the US go into recession, Australia is likely to see lower interest rates, which means that bank account paying 6% now is likely to be offering a much lower rate down the track. The dividends are also fully franked, which improve the before tax return.

Anyone want to try doing business without a phone or internet connection? Telstra Limited (ASX: TLS) is another contender. With a high dividend yield, the company provides essential telecommunication services to many retail and corporate customers. It does have its fair share of debt, but also generates substantial cash flows. Despite the current price of over $3.90, Telstra is still paying a 7% fully franked dividend yield. Limited (ASX: CRZ) may be an unusual pick, but if you think about it  – what do tough times mean for consumers who might need cash? Some may be forced to sell the second car, or even their first. People may also be more likely to buy second-hand cars rather than new ones. With its dominant position in online car sales and trading, no debt, and currently paying a 3.5% dividend, could be a good pick.

I told you that there were some exceptions to companies with offshore operations and at first glance Cochlear Limited (ASX: COH) may not appear cheap. The company is currently paying a dividend yield of 3.8%, and the company’s products that enable people to hear will likely be in demand, no matter what the global economy is doing, particularly because government’s tend to pick up a large percentage of the costs.

If you want more diversity than the stocks above, you could also consider one of the electricity and gas suppliers Origin Energy Limited (ASX: ORG) or AGL Energy Limited (ASX: AGK). Origin may be the better pick as it is also exposed to the liquefied natural gas sector – which could provide growth, is paying a 4.4% dividend currently and on a P/E ratio basis looks slightly cheaper.

The Foolish bottom line

A portfolio of the stocks above could be a good to start to “weather the oncoming storm“, should the doomsayers be right.

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Motley Fool writer/analyst Mike King owns shares in Cochlear and Woolworths. The Motley Fool‘s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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