A Defensive Dividend Investing Strategy That Generated 45% in 24 Months

Investors sometimes talk about going defensive only to protect themselves from sharp downside movements. All too often they associate defensive stocks with hedging tools that provide little upside potential. What if you could pick a defensive investment risk management strategy that also provided market-beating gains over the past 10 years? Read on to find out how defensive can also be offensive in these bad markets.

Utilities and MLPs
This isn't another one of those boring lectures on utility companies. To whet your appetite, this defensive strategy delivered a whopping 44.9% return over the past two years, amazing when you consider the market was totally flat last year and up only 11% in the trailing 24 months. What defensive stock picking strategy could deliver those sorts of gains in a choppy market? Look to boring utilities and MLPs that put high-growth investors to sleep.

What makes these two types of investments worthwhile? Even during difficult times, people still need to heat and light their homes. Publicly traded MLPs (Master Limited Partnerships) distribute cash-flows to shareholders, or more correctly to unit-holders. They focus on exploration, production, transportation, storage, and processing of natural resources. The pipeline and storage industry has defensive properties as it makes money on the volume transported and not the fluctuating price of the commodity. If this seems too complicated, try to think of them as REITs in natural resources. That's not a perfect analogy, but it'll do for now.

A Simple Strategy
You can easily employ this simple strategy. We look for a dividend yield (or cash distribution) of at least 5% and we focus on U.S. companies. We also look for long-term dividend and earnings growth; if either is negative over a five-year average, we exclude the company from our list. Our only selling rules are when the five-year average dividend or earnings growth turns negative. We target a maximum of six stocks. This chart compares the strategy with the broad market over the past two years along with some statistics:

This strategy is suitable for passive buy and hold investors who hate selling in a secular bear market and prefer little share turnover. We picked up these two companies during the past two years:

1. CenterPoint Energy (NYSE: CNP). This is a public utility holding company involved in electric and natural gas transmission, amongst others. The yield now sits around 4% due to a two-year price run-up of 37%.
2. Williams Partners L.P. (NYSE: BPZ). This is an MLP focused on natural gas transportation. Current yield is just under 5%. We picked up this stock on February 22, 2011 at $50 and it has returned 24% capital gains since then, in addition to cash flow distributions.

Is this a sound strategy for 2012? To answer that in part, we should backtest this strategy over the past 10 years. I randomly tested this strategy with over 550 random entry points and one-year holding periods to check for robustness. This strategy averages 12.62% annually before adding in over 5% yields. This is three to four times higher than the market on average.

Current Defensive Picks
Some companies to consider with this simple strategy include Boardwalk Pipeline Partners BWP, DCP Midstream Partners DPM, Enterprise Products Partners EPD, Exelon Corporation EXC, and TC Pipelines TCLP. If you lower the dividend yield bar slightly, you might choose from other utility companies, such as Pinnacle West Capital Corporation PNW and Consolidated Edison ED.

Smoothing the Bumps in 2012
Will 2012 be another good year or will our strategy fall flat, since past performance does not guarantee future results? A lot of market uncertainty still exists around the Eurozone crisis. Bond rates have fallen and investors looking for lower risk need somewhere to park their cash while seeking modest returns.

With high frequency trading practices flooding the market and capitalizing on fear, hedge against volatility by adding some utilities and pipeline MLPs to your equity portfolio. History proves there is upside and the future uncertainty suggests it may be another good year to stay defensive. If you have a strong dislike for volatile markets and want to find bond-like stability with larger yields than what governments can currently offer, consider buying a few defensive utility stocks and MLPs for a smoother, and hopefully more profitable, ride in 2012.

Kurtis Hemmerling is an dividend stock investor and shares his tips and strategies on the Money Crashers personal finance website.