3 Best Defensive Picks

01/03/2012 11:00 am EST


Paul Larson

Editor, Morningstar StockInvestor

In the defensive sectors, Paul Larson, editor of Morningstar StockInvestor has three stocks that he likes as we head toward 2012.

Paul, I’d like to get your ideas of stock picks in the utility or health-care sector.

Sure. When you look at utilities, one of the names that really stands out as being of value right now is a company called Exelon (EXC).

Though it’s technically a utility, it’s really not. It’s primarily a merchant power generator, meaning they’re largely unregulated businesses that sell into the wholesale market. They own the largest nuclear power plant, Fleet, here in the United States.

Because they are the largest with this relatively low-cost source of power, we do think that this company does have a wide moat, because again the lowest cost to produce electricity. Also, its nuclear power does not have any sort of carbon emissions, so when you’re looking at greenhouse gas regulations down the road, this company will be sitting pretty.

Even if that pie in the sky doesn’t happen, we are continuing to see tightening regulations around other pollutants like nitrous oxide and sulfur and such. With the EPA continuing to tighten those regulations and really clamping down on coal, Exelon with these nuclear power plants that don’t have any air emissions are really sitting in a good position.

What about its pending acquisition of Constellation Energy. It appears to be against it.

Yes, actually we are—Morningstar and myself personally—are very against the merger with Constellation Energy (CEG), because we think for one, Exelon is so-called "diluting" its moat because it’s a relatively strong company buying a company that’s relatively weak, so we don’t like that.

Also, they’re overpaying, so we don’t like that either. They’re overpaying using their undervalued stocks. So it’s three strikes and you’re out with this potential merger.

With that said, even if the merger does go through and Exelon dilutes its value, we still see value in the shares. We still think it’s worth somewhere in the mid-$50s versus the low $40s, where the stock trades today.

Likewise, if the Constellation merger were to get called off, we think the stock would be worth more than the mid-$50s, maybe around $60 or so. So we’re hoping that the merger does get called off either by shareholders or by regulators. Even if it doesn’t, you’re still looking at a stock that looks undervalued.

How about the health-care sector?

Sure, my favorite stock in the health-care sector today is Pfizer (PFE). This is a stock where I think there’s a lot of concern because the company is losing its Lipitor patent here in late 2011.

When you look to 2012, the company is going to see earnings go down, but the company should see earnings still in the neighborhood of $2 to $2.20 a share, somewhere in that neighborhood. Meanwhile, the stock is in the high teens.

So post-Lipitor, you’re still looking at a stock that’s trading somewhere around eight or nine times earnings, which seems like a low price to pay for a relatively high-quality company. It’s not the best company in the health-care space, I’ll certainly concede that point, but it is arguably the cheapest.

Does it have anything in the pipeline to replace Lipitor?

Sure, it has a couple things in the pipeline. I don’t think you’re ever going to completely replace Lipitor. I think this is really one of the best selling drugs of all time. So I don’t know if you’re ever going to completely replace it, but they have a couple treatments in the pipeline.

One is for rheumatoid arthritis, which has a lot of promise. This is also a therapeutic area that is relatively underpenetrated and a lot of the existing therapies are injectables. Pfizer’s is one that you would take as a pill so it would have a competitive advantage.

So for Pfizer this is not going to return to its superstar status that it had in the late 90s, early 2000s. With that said, when you’re looking at a stock that’s trading at eight or nine times earnings, clearly the expectations priced in are exceptionally low...and in my opinion likely to be exceeded.

As opposed to being confident in the market returns, where would you be looking for opportunity at least getting investors to start watching?

Right. There are a large number of firms out there that are still trading at 11 or 12 times earnings despite being relatively high-quality firms. Take 3M (MMM) for instance—high-quality firm, long history, solid dividend, decent growth, with the majority of its business outside of the United States...not so much in Europe, but in other emerging economies.

This is a firm that though it does have a little bit of economic sensitivity, it’s still positioned quite well in a large number of its markets. Frankly, the stock is just plain cheap.

Do you own for your own personal account any of the stocks that you mentioned?

Yes, I actually own all the stocks I mentioned. At Morningstar, we like to stay that the cook is eating the cooking.

So if I make a good recommendation, I’m going to benefit myself and likewise I have a strong incentive not to make bad recommendations. So I do own Pfizer, 3M, and Exelon.

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