What are Defensive Stocks?
Defensive stocks provide constant dividends and steady earnings to shareholders irrespective of how the market is performing. These companies are called defensive stocks because they showcase consistent demand for their products, making their stock stable during various phases of business cycles. In other words, these stocks belong to industries that produce products with constant demand irrespective of economic conditions. Moreover, these stocks are also called non-cyclical stocks.
Generally, defensive stocks offer substantial benefits in the long term with lower risk than other stocks. On the downside, these stocks are less volatile, protecting the portfolio from losses. Thus, these stocks perform better than the broader market during the recession. On the other hand, during the expansionary phase, they tend to perform below the market.
The following is the list of industries of defensive stocks –
- Utilities: Utilities like water, gas and electricity are the basic requirements for living. Thus, the demand remains the same and is least affected by market changes. Moreover, during the recession, these companies take advantage of borrowing loans at a low-interest rate with minimum competition. For example – Coal India, Power Grid Corporation, Hindustan Petroleum, etc.
- Consumers Staples: Companies producing or distributing consumer goods belong to this category. They include food, beverages, household items, hygiene products, tobacco, etc. This category is the daily requirement for individuals and has a certain cash flow in all economic conditions. For example – Dabur, ITC, Hindustan Unilever, Dabur India, Nestle, etc.
- Healthcare: Medical aid is required irrespective of the economic condition. Thus, major pharmaceutical companies and manufacturers of medical devices are considered defensive stocks. However, there has been an increase in competition with new brands and generic drugs, which makes these stocks less defensive. For example – Apollo Hospitals, Fortis Healthcare, etc.
Features of Defensive Stocks
The following are the key features of defensive stocks –
1. Sectors Don’t Go Out of Fashion
Some sectors like FMCG and food products can never go out of fashion. There is hardly any change in consumption patterns in these sectors. In fact, the demand increases when the income levels increase in the economy. However, they have a stable demand and tend to be less volatile. Also, such stocks manage to protect prices and returns in tough times. Thus, defensive stocks can protect the portfolio during market fluctuations.
2. High Dividend Yield Stocks
Defensive stocks offer a high dividend yield, making them very attractive at lower levels due to the annuity income they generate. The dividend yield acts as the price support for these stocks. Also, these companies use retained earnings for business expansion and distribute dividends to shareholders. Some popular companies in India that fall under this category are Coal India, REC, Chennai Petroleum, etc.
3. Non Cyclicality in Demand
Because of consistent demand, sectors like utilities, FMCG, and healthcare are defensive stocks. Consumers will continue to use utility goods and services regardless of how the market performs. Similarly, personal care sectors like soaps, toothpaste, etc., are popular defensive stocks. Hence, whether the market is good or bad, people will continue to consume gas, water and electricity.
4. Matured & Stable Business Model
Some businesses have a matured and stable business model, like, Tata Group, etc. These companies have a strong advantage over their competitors as they can protect their market share and profitability longer. Thus, this feature of defensive stocks can perform in all market conditions.
5. Low Valuation Stocks
This is another feature of defensive stocks where most companies have relatively undervalued in terms of P/E ratio and P/B ratio. Thus, many companies are still available at fair market valuations. Also, this principle is applicable to sound business models and not every company with low valuations. Moreover, these stocks have the potential to protect the significant downside risk.
6. Low Beta Stocks
Beta indicates the stock’s volatility against the market. Stocks with a beta of less than one are less sensitive to market movements in the stock market and changes in economic conditions. Thus, stocks with low beta tend to be defensive because they are less volatile.
When Should You Invest in Defensive Stocks?
The following are the conditions where you can invest in defensive stocks –
- When the markets are volatile, defensive stocks can be a stable investment option. This stock works as a cushion against volatility.
- As an investor, you don’t have a proper understanding of markets.
- Usually, these stocks provide a high dividend yield. You can prefer defensive stocks when looking for dividends from your stock investment.
- When you don’t have a proper understanding of risk and market fluctuations, defensive stocks provide consistent returns in the long term.
- During the recessionary phase, these stocks work well in one’s portfolio.
Factors to Consider Before Investing in Defensive Stocks
Defensive stocks are suitable for investment because they have steady demand and can handle economic stability. However, the following are a few factors that you must consider before investing in them –
1. Stock Beta
This is a measure of stock volatility compared to the broader market. Defensive stocks tend to have a lower beta (less than 1) because they are less affected by market fluctuations.
2. Past Dividends
Companies that pay consistent dividends over the years (even during recessions) are more reliable and perceived to have strong cash flows. However, it is not the only way to evaluate this stock. Some companies have a combination of high dividends and price growth compared to their peers. While some have seen the price fall but continued to pay dividends.
3. Financial Valuation Ratios
Using various ratios like dividend yield, P/E, P/B, etc., will help you to understand the stock movement in the short, medium and long term. Thus, these ratios help to make informed decisions about selecting the stocks to trade.
4. Extensive Research
It is essential to do extensive research on any stock before investing. The different factors that investors can look for while evaluating a stock are performance growth, brand value, sales turnover and valuation ratios. If the company is consistently failing, there are no proper marketing strategies, and no innovations per trends and needs, then these defensive stocks may not be a good option to invest in. For instance, some companies outperformed but slowly depleted and became non-existent in the market.
5. Consumer Trust
Another metric that you must consider while evaluating these stocks is consumer trust. Sometimes, a brand may look shiny, but the customer feedback and the service at ground level may not be good. Ultimately, a consumer is the one whose needs are to be satisfied. Thus, conducting ground-level research about customer opinions can directly impact the company’s performance.
6. Competitive Edge
Competitive edge helps to understand the future of these stocks while investing. You must analyse that the company’s strategy and performance are competitive compared to others within the industry. Thus, you must research all competitors within the industry before picking a stock.
Who Should Invest in Defensive Stocks?
Every investor wants to hedge their portfolio against market volatility while they earn returns from their investment. A steady and consistent return can help investors survive during challenging economic periods. Thus, defensive stocks are suitable for investors who want to protect their portfolio from further losses, especially during recessions. Investors can choose to invest a certain percentage of their portfolio in these stocks. Also, these stocks provide a high dividend yield, which makes them attractive for addition to an investor’s portfolio.
Defensive stocks are also suitable for investors who do not have much knowledge about the stock market. Such investors can invest in these stocks to understand the market rather than burning capital by investing in aggressive stocks. Therefore, investors with a low understanding of risk can prefer defensive stocks as it has the potential to deliver stable returns.
However, investors must remember that these stocks do not give bumper returns but provide relative stability to the overall portfolio. Thus, it is essential to adopt due diligence while selecting a stock to make an informed decision.
Advantages and Disadvantages of Defensive Stocks
The following are the advantages of defensive stocks –
- Stability: One of the significant advantages of these stocks is that it helps to create a balanced portfolio with a combination of low beta and high beta stocks. These stocks provide steady and consistent returns over time. It helps to create a balance in overall portfolio risk.
- Low risk: Investing in these stocks helps investors protect from further losses. They offer low-risk investment opportunities in the long term. Also, such stocks are not affected by market fluctuations.
- Dividend yield: These stocks have the capability to promise investors regular dividend payouts.
- Outperformance during the economic downturn: The portfolio of defensive stocks provides stable returns even during the recessionary phase. Because the demand for goods and services of these companies remains inelastic irrespective of economic conditions. Moreover, these stocks perform better during sluggish markets.
The following are the disadvantages of defensive stocks –
- Slow growth: The flipside of these stocks is that investors experience slow growth from their investments. You will rarely see rapid growth in such stocks. In other words, they do not appreciate considerably at a price and may take longer to rise.
- Overvalued: Some of these stocks can be overvalued during economic decline. Thus, when you are investing in a stock because it is a safe bet during this phase, it may lead to investing in an overvalued stock and may not give returns as per expectations.
- Underperformance during economic growth: In a robust economy, when other stocks rise, they stay where they are in terms of growth. Thus, holding too many defensive stocks in your portfolio can be harmful, especially when the markets are performing well.
Difference Between Defensive and Cyclical Stocks
A Defensive stock is also called a non-cyclical stock because these stocks provide steady returns irrespective of the economic conditions. These stocks showcase consistent demand for their goods and services, making them stable during different phases of business cycles. This is because the goods and services these companies provide are related to the everyday needs of every individual like food, water and utilities. For example – consumer goods, healthcare, utilities, etc.
As the name suggests, cyclical stocks are directly affected by economic changes and depend on the order of business cycles. The product value also increases when the business is in demand, which is season-specific. This leads to more sales and turnover during this period. Similarly, cyclical stocks have lower sales during the off-season, and stock prices fall, making them volatile. Thus, investors can buy stocks during this phase and sell them during the peak season. For example – automobiles, travel, fertiliser, etc.
The following table shows the differences between defensive stocks and cyclical stocks –
|Parameter||Defensive Stock||Cyclical Stock|
|Performance||This stock delivers steady performance irrespective of the economic conditions.||The performance of this stock is dependent on the economic conditions.|
|Risk||Low risk stocks||High risk stocks|
|Volatility||Less volatile||More volatile|
|Beta||Lower than 1||Higher than 1|
|Returns||Steady returns||Seasonal returns|
Defensive stocks are a way to mitigate portfolio risk. However, most investors prefer diversified investment strategies that combine cyclical stocks and growth stocks. Therefore, investing in stocks is all about finding the right balance.