What are defensive stocks?
A defensive stock is a type of stock that provides consistent dividends and stable earnings irrespective of the overall economic state; they are also known as noncyclical stocks. In other words, the value of stocks is not determined by the state of an economy. There is a constant demand for their products as defensive stocks tend to be more stable during the various phases of the business cycle.
It is important to note the difference between defensive stocks and defense stocks. Defense stocks are the stocks of companies that manufacture ammunition, weapons, and fighter jets.
Investors that seek to protect their portfolios during a weakening economy or periods of high volatility may consider increasing their exposure to defensive stocks.
The stocks of companies like Procter & Gamble, Philip Morris International, Coca-Cola, and Johnson and Johnson are considered defensive stocks. Aside from strong cash flows, these defensive stock sectors have stable operations with the ability to withstand weakening economic conditions. They also pay dividends which can have the effect of absorbing the price of a stock during a market decline.
Defensive stocks are less likely to be faced with bankruptcy because they have relative strength during economic downturns. They accommodate greed because they offer a higher dividend yield than can be achieved in low-interest-rate environments. Also, defensive stocks reduce fear because they are less riskier than regular stocks and it usually takes a significant catastrophe to take their business model off track. In essence, they outperform the market during the economic crisis.
Defensive stocks seem to have a track record of having a consistent performance or even better during a stock market crash or recession. This is so because they belong to sectors where the demand for their products is constant including food and beverages, utilities, and healthcare services. Such products do not usually experience a major change in demand throughout the year and are said to have inelastic demand, meaning that a change in price will not significantly impact demand.
Because of this, defensive stocks are usually seen as a type of safe-haven asset that investors may buy and hold as a way to hedge against risks associated with the portfolio. This implies that during an economic downturn when cyclical sectors are underperforming, defensive stocks remain strong and may help in balancing out the risks in one’s open positions in economically sensitive areas.
Defensive stocks examples
- Consumer staples
Companies in the water, electric, waste management, and gas sectors offer necessary services and still have normal operations during economic downturns. People need them during every phase of the business cycle. Also, utility companies benefit from a slower economic environment since interest rates tend to be lower.
During economic downturns, consumers cut down their budgets for necessities. Here, it is not possible to eliminate staples like tobacco products, toiletries, food, and beverages. The stocks of these sectors are considered defensive stocks since they outperform the economy during downturns.
Another good or service that consumers will continue to purchase in an uncertain economy is healthcare. It also performs well during recessions. These sectors include pharmaceuticals, insurance, medical devices, and hospitals. Their shares are considered defensive stocks.
Telecommunications such as cable, phones, internet service providers, etc, are goods and services that will never stop being in demand. Although they might cut back on or downgrade during hard times most often, these businesses have revenue that is pretty stable. Such companies have defensive stocks.
Features of defensive stocks
- Never go out of fashion
- No element of cyclicality
- High dividend yield
- Matured and stable business models
- Conservative valuations
- Low beta
Never go out of fashion
One feature of such stocks is that they never go out of fashion, they have increased demand as the income levels in the economy increase. They are less volatile and have the capacity to protect prices and returns during tough times because they carry a stable nature.
No element of cyclicality
If a stock goes through typical seasonal cycles or moves according to the global economy commodity cycles, then we cannot consider such stocks as defensive. This implies that a defensive stock has no element of cyclicality.
High dividend yield
In bad times, defensive stocks have high dividend yields. Typically, stocks that have dividend yields above 6 to 7 percent are classic examples of defensive stocks. Their attractive dividend yields make them attractive at lower economic levels because of the annuity income that they generate. Therefore, this dividend yield serves as price support for the stock.
Matured and stable business models
Defensive stocks are said to have matured and stable business models irrespective of the changes in the phases of the business cycle.
Defensive stocks also have conservative valuations. They can be stocks that are relatively undervalued in terms of the P/E ratio and P/BV ratio. Such stacks have the ability to protect one’s downside risks.
A defensive stock can also be characterized by a low beta, which is a beta lower than 1. Such stocks hold value more effectively when the markets are down or too volatile.
- Outperforms economic decline
In most cases, market volatility scares some consumers away from investing and the stable nature of defensive stocks proffers solutions to this. If one pads his portfolio with these predictable performers can act as a defense against sudden swings in the stock market.
The low-risk nature of defensive stocks makes them more attractive to investors who place priority on protecting their wealth against loss. The low-risk companies maintain their value and the value of investors’ capital over time.
Outperforms economic decline
During economic downturns, this category of stocks tends to do better than their cyclical counterparts. Theoretically, this can strike some balance to any losses that the growth stocks experienced during a recession.
- Low growth
- Can be overvalued
- Underperforms during economic growth
One disadvantage of defensive stocks is that they rarely experience rapid growth. It is possible that they preserve their value over time but one is probably not going to get rich from them.
Can be overvalued
In periods of economic decline, defensive stocks are usually overvalued. If one is pushed by the worries about the economy to go after stock and then sees it as a safe bet, there are a lot of other people that are probably doing the same. This can cause the value of the stock to be artificially inflated during a downturn.
Underperforms during economic growth
When other stocks are flourishing in a strong economy, defensives are more bound to remain where they have always been in terms of growth. This implies that holding too many of this form of stock can hurt one’s portfolio when the market is doing well.
Defensive vs cyclical stocks
The major difference between cyclical and defensive stocks is that defensive stocks do not follow the cycles of the economy. In fact, there is a typical underperformance during economic growth.
On the other hand, cyclical stocks are those stocks that tend to do well when the economy is strong and decline when there is an economic downturn. In other words, the term “cyclical stocks” is the opposite of defensives.
Another area in which these stocks differ has to do with the industries under which they operate. Being in industries that can withstand recession such as utilities, consumer staples, and healthcare which are the examples mentioned above have the ability to withstand the ups and downs of the business cycle thereby making them less volatile.
Industries with cyclical stocks include automobile industries, aviation, hotels, etc. Cyclical stocks are usually in industries that struggle during economic hardship. This is because they offer goods and services that people cut out of their budgets when they are short of cash.
What are examples of defensive stocks?
Examples of defensives are the stocks of utilities such as electricity, consumer staples such as food and beverages, healthcare such as pharmaceuticals and medical devices, and telecoms such as phones, internet service providers, and cables.
Which stock sectors are defensive?
Some of the stock sectors that are defensive are the utility sectors, healthcare sectors, consumer staples, etc. These sectors provide basic necessities that consumers cannot cut off when the economy is down.