Defensive Stocks

Defensive stocks shield your portfolio from severe downturns in the economy and the stock market. In fact, stocks that fall under the defensive category normally have little correlation between their profitability and the movement of the economy and the market, up or down. Their defensive status comes from their overall stability in relation to more volatile stocks and at the typical cost of less appreciation and growth when the economy is strongly expanding.

Defensive stocks perform consistently because the goods and services they provide to consumers have sticky demand. Consumers need the products these companies provide no matter what the condition of the economy.

Typical defensive sectors include utilities, consumer non-cyclicals or staples, health care and telecommunications services. Companies such as Tyson Foods Inc. (TSN), a food manufacturer and processer; Procter & Gamble Co. (PG), a personal products manufacturer; and Philip Morris International Inc. (PM), a tobacco company, are examples of consumer non-cyclicals.

Also referred to as non-cyclical stocks in general, defensive stocks contrast with the stock of companies that are impacted more directly by cycles of the economy. Cyclical stocks rely on consumers’ confidence to spend discretionary income, based on their belief that the economy will continue to grow for the moment.

However, a defensive stock is not simply a company that falls into a specific sector or industry. A truly defensive stock should exhibit basic traits in relation to its business fundamentals.

A defensive stock is an established company with a history of success, usually with a market cap in the billions. The company typically pays a dividend and has done so consistently for a long period, at least for a decade. In terms of volatility, the stock has a low beta, below 1.0. (Beta is the measure of a stock’s volatility relative to the market as a whole.)

Investors can also think of blue-chip stocks as being defensive stocks, though they are not necessarily non-cyclical stocks. Blue chips are considered high-quality investments in mature companies that dominate an industry. They are considered to be a low-risk stock investment.

What Are Defensive Investments?

Conservative investors are attracted to defensive stocks because they offer an opportunity to preserve their principal and their investment gains. A contrarian such as Vanguard founder John Bogle believed that in the long term it is limiting losses that allows you to beat the market, not chasing gains. These investors are attracted to the advantages of defensive stocks: stability, lower risk and outperformance during periods of economic decline.

Conversely, aggressive investors eschew defensive stocks because their advantages are viewed as disadvantages. Aggressive investors primarily seek growth from stocks in the form of capital gains. Defensive stocks producing consistent returns based on non-cyclical patterns are typically not growth stocks.

Although defensive stocks may outperform cyclical stocks during periods of economic decline, defensive stocks tend to underperform cyclical stocks when the economy heats up again and the market becomes bullish. In market recovery, upswings out of a bear market may account for strong sudden growth for many stocks. Defensive stocks usually miss out on this trend due to their low beta and may even see their share prices fall as investors rotate their portfolios away from a conservative strategy into a more aggressive one.

It is also possible for defensive stocks to become overvalued when investors rotate into a defensive strategy en masse. For this reason, it is generally not a good idea to try to time the market or make wholesale allocation changes during economic upheavals.

The best way to incorporate defensive stocks into your portfolio is through diversification. Following a portfolio allocation strategy that covers wide parts of the market ensures that you are exposed to the right types of stocks at the right times.

Investors should also consider exchange-traded funds (ETFs) and no-load mutual funds as alternatives to owning individual defensive stocks. Funds offer the benefit of being professionally managed to achieve their outlined objectives and are already diversified from the perspective of being a basket of investments. Funds also have the benefit of being more liquid than other types of defensive investments such as annuities and real assets like gold.

Conclusion

Defensive stocks in general do not lose their value as the rest of the market does during periods of economic downturn. Stocks are deemed defensive for having stable sales and earnings, essential consumer products with sticky demand, a long history of surviving through economic cycles and paying dividends and lower volatility. Often, defensive stocks are part of non-cyclical sectors and industries.

Defensive stocks are great for investors who want to invest in stocks while preserving long-term gains with lower volatility. For the average investor, beating the market is usually easy to achieve if you are not chasing gains; most of the battle is in preventing easy losses.

With this in mind, maintaining a portfolio allocation strategy that diversifies with defensive stocks is an effective way to keep your portfolio from tipping too far in one direction during different economic cycles. Stocks and other investments will perform differently depending on the economy and the market.