Defensive stocks are stocks that demonstrate relatively stable performance regardless of the state of the economy. Defensive stocks are also called non-cyclical stocks, as they are less prone to the economic cycle of expansion and recession. Defensive stocks come with a steady dividend payment and a more constant share price.
What are Defensive Stocks.
Defensive stocks are those which provide constant returns in the form of dividends regardless of the fluctuations in the stock market. These shares tend to remain stable during various phases of the economic cycle. Even at the downturn of the economy, defensive stocks give stable returns, though at a time of economic boom these stocks tend to lose the opportunity to earn high returns. These stocks belong to industries that produce products which remain in demand irrespective of the state of economy. For instance, utilities, health care, personal care, FMCG etc. Essentially, the sales of such products remain unaffected by market swings.
Industries Covered by Defensive Stocks.
There are three main defensive sectors: Utilities, Consumer Staples, and Health Care.
Utilities. Utilities like water, gas, and electricity are needed in all phases of livelihood or business cycles. Hence their demand remains constant in all phases of the economy and is not affected by market changes. Further utility companies draw benefits at the time of recession as they get borrowings at lower interest rates with minimal competition.
Consumer Staples. Consumer staples include food, beverages, household items, tobacco, hygiene products, etc. These are daily use products that have a certain demand in all economic conditions. So, these stocks tend to outperform during weak economic conditions and underperform when strong economic conditions prevail.
Healthcare Stocks. Stocks of pharmaceutical companies and manufacturers of medical devices are defensive stocks because medicines and medical aid is required irrespective of the economic phase/cycle. Along with healthcare, companies producing FMCG products like toiletries, cosmetics, cleaning supplies, and other low-cost household items are also considered defensive stocks.
Advantages of Defensive stocks.
Defensive stock offers the following advantages:
Stability. Defensive stocks offer steady returns for a long time since these stocks remain in demand even amidst market volatility, offering a sense of security. These stocks may be suitable for investors who cannot handle higher volatility.
Lower Risk. Investing in these stocks involves lower risk, as these stocks are less likely to lose their value significantly. It may suit investors who prefer capital protection over high risk.
Outperformance In Recession. During times of recession companies experience temporary drop in revenue, but these stocks are likely to perform better than the overall market. Their earnings may still remain stable allowing them to pay dividends. Many investors move towards these stocks during an economic downturn.
Regular Dividend Payouts. Defensive stocks have a history of regular dividend payout providing investors with a steady income.
Disadvantages of Defensive Stocks.
There are some disadvantages of defensive stocks: –
Limited Growth Potential. Defensive stocks represent mature companies that are well established and may not show spectacular growth. Hence these stocks don’t usually offer quick and significant returns. Though they may help investors protect their wealth, but they may not help them build it fast.
Higher Price. Since many investors turn to these stocks during an economic downturn, you may find these stocks overvalued or high-priced. If the stock’s demand is high, the price will rise, reducing your potential returns.
Underperformance in an Economic Boom. When the economy slows down, these stocks may perform well. However, when the economy booms, they may not do as well, and an investor would not see high growth or great returns. Therefore, investing requires knowledge of current market conditions.
Regulatory and Sector Risks. Certain sectors such as Utilities and Healthcare are subject to regulatory changes and industry specific risks which could affect these companies and hence their performance.
How to identify defensive stocks.
Beta measures a stock’s volatility in relation to the overall market. It indicates how much a stock may rise or fall relative to the stock market. Lower beta value indicates less volatility. Defensive stocks usually come with a low beta because they are less affected by market swings. Traditionally they come from sectors that produce necessities or consumer staples so regardless of market dynamics these will be in demand.
Examples of Defensive Stocks
Defensive stocks are not correlated with the business / economic cycle. Examples of defensive stocks include utilities, healthcare and consumer staples or essential household items.
Utilities. Water, gas, and electric utilities are examples of defensive stocks because people need them during all phases of the business cycle.
Consumer Staples. Stocks of companies that produce or distribute consumer staples or goods that people tend to buy out of necessity are defensive stocks. They include food, beverages, hygiene products, tobacco, and certain household items. Consumers will find a way to buy them regardless of economic conditions.
Healthcare Stocks. Shares of major pharmaceutical companies and medical device makers are considered defensive stocks since there is always demand for medicines. However, they aren’t as defensive due to increased competition from new drugs and uncertainty surrounding regulations.
How to use defensive stocks in a portfolio.
Defensive stocks in any portfolio are used primarily to help reduce the volatility of returns. This can be done in many ways. One technique is to target stocks with lower levels of historical volatility. Some companies, due to industry, competitive position, or strong financials, have records of lower volatility in down markets. Targeting those stocks can help to limit downside risk during selloffs but will require considerable research / study.
Another is to select securities that can offer inflation protection from a given market environment. For example, if inflation is high, an investor might select Treasury bills to help protect the portfolio’s value. If inflation and growth are both low, as in a recession, the investor may choose investment-grade bonds that could offer protection from the risk. Continued detailed examination of the defensive stock portfolio ensures that they are in line with your investment objectives and risk tolerance.
Conclusion.
Defensive stocks can provide stability of returns despite turbulence of financial markets, owing to their steady performance and reliable dividend payments. Defensive stocks are also called non-cyclical stocks, as they are less prone to the economic cycle of expansion and recession. However careful analysis of past performance and industry dynamics is required before including defensive stocks in your investment portfolio.
