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It is often said that diversification is the only “free lunch” on Wall Street, because the practice allows investors to reduce risk in their equity portfolios without lowering their returns. Just how much diversification is necessary or optimal is a frequently debated topic by modern portfolio theorists. But, given the heightened volatility in the equity markets since the global financial crisis of 2008/2009, investors would surely do well to hold a wide assortment of stocks with different risk profiles. (Diversifying among different asset classes, from U.S. Treasuries and corporate bonds to precious metals and real estate, is also advisable, but that’s a subject for another day.) This includes some noncyclical, defensive-oriented issues, picked from the historically stable food and beverage, utility, health care, and pharmaceutical industries, that can be counted on to hold up pretty well in the midst of a sharp market correction.

One of our favorite defensive plays, one suitable, we think, for even the most conservatively managed accounts, is Hormel Foods (HRL). The Austin, Minnesota-based company, founded back in 1891, is the largest producer of pork and turkey products in the U.S., with more than 18,000 employees and annual sales of about $7.5 billion. The company operates five business segments: Grocery Products (14% of the top-line mix in fiscal 2010, which ended last October); Refrigerated Foods (53%); Jennie-O Turkey Store (18%); Specialty Foods (11%); and All Other (4%). And it maintains an enviable roster of popular consumer brands, from SPAM canned luncheon meats and Dinty Moore stew to Hormel chili and Natural Choice meats.

The company has its roots in the cutthroat, low-margined meatpacking business, where price, above all else, dictates customer behavior. In recent years, however, thanks to an experienced, proactive management team, it has been steadily moving up the value chain. Indeed, Hormel has been packaging/processing more of its basic meat products and selling them on a branded basis. This trend, likely to persist through mid-decade, has helped the company to become more profitable, enhance its pricing power, and reduce its exposure to unpredictable commodity cost fluctuations.

As things now stand, Hormel’s financial results, like those of rivals Smithfield Foods (SFD) and Tyson Foods (TSN), are still heavily influenced by prices for live hogs and agricultural commodities, like feed grain. But earnings volatility should decline over time, as the company makes further progress with its value-added strategy. (Hormel is on track to meet its latest goal, outlined in mid-2008, of introducing around $2 billion in new branded products by next year.) Indeed, with an established line of branded consumer goods, the company should be far better positioned to pass along higher input costs to its customers in the form of price hikes.

Margins, meanwhile, ought to benefit from more favorable supply/demand dynamics in the protein markets. (Many of the largest industry players, mindful of the problems caused by bloated global inventory levels, have been scaling back production.) And we expect improved hedging techniques, resulting in fewer hogs being purchased on the spot market, to render Hormel’s bottom line less vulnerable to commodity-related shocks in the years to come.

Surveying the company’s balance sheet, there’s plenty for investors to like, which is one of the things that makes Hormel shares a nearly ideal defensive play. The corporation has $965 million in cash and short-term investments on its books, and a debt-to-capital ratio of less than 10%. (This debt level is quite low, even by the standards of the quality food industry.) What’s more, free cash flow is sizable. These factors support a decent dividend payout -- the yield is just under 2% at present -- and a fairly ambitious acquisition agenda.

Hormel has been an active sector consolidator in recent years, as it has endeavored to expand its product portfolio and morph into more of a consumer-oriented packaged food outfit, similar to the likes of ConAgra Foods (CAG) and General Mills (GIS). It has been particularly aggressive in adding to its lineup of Mexican fare, since this is among the faster-growing niches in the domestic industry. In fact, in late 2009, the company entered into an important, 50/50 joint venture with Herdez Del Fuerte to market Mexican foods in the U.S. And the partnership, doing business as MegaMex Foods, has since been enhancing its arsenal via acquisitions, most recently buying Don Miguel Foods, a leading provider of branded frozen and fresh Mexican-themed appetizers, snacks, and handheld items. We expect more deals to come, which should significantly enlarge Hormel’s revenue opportunity, and help the company to leverage its vast production and distribution infrastructure.

All in all, we think that Hormel shares, while not especially exciting, are an excellent defensive holding for longer-term investors. The stock carries our Highest (1) rank for Safety. And it appears reasonably valued, trading at roughly 17 times forward 12-month earnings. We would note that the shares should continue to be assigned a higher P/E multiple by the market than has been the historical norm, as Hormel further deemphasizes its meatpacking operations and sells more high-margined, value-added products.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.