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Define defensive stocks

by Gino D’Alessio

Defensive Stocks: Pros and Cons And When you should Trade Them

Definition of Defensive

Defensive stocks are known as such because they are not as susceptible to the market cycle as other stocks. They are also known as non-cyclical stocks as their price does not follow the economic cycles to the same extent as cyclical stocks. Usually, stock prices will change with the economic cycle; prices typically peak just before the economy turns into a contracting phase and prices usually begin to rally again just before the economy turns back into an expansion phase.

Defensive stocks will not be as affected by the economic cycle as much as the broader stock market is. These corporations usually offer some type of service or goods that have a very flat demand curve. This means that demand is very sticky and does not change very much for each increase or decrease in price. The effect of a substantially stable demand is to create relatively stable incomes and revenues for these companies. Because of the reliability of these company’s cash flows, they also tend to pay consistent and high dividends.

Why invest in Defensive Stocks?

Defensive stocks are the type of shares investors turn to when they fear a strong bear trend lies ahead. They are also considered a necessary part of a well-diversified stock portfolio. The reason they are deemed useful in times of market distress or in terms of diversification is due mainly to the fact that they generally less volatile. Therefore, they are less likely to see the same reductions in share price as would be the case with cyclical stocks. This phenomenon is known as Beta, which is the extent to which a share price will change when compared with the broad stock market.

A stock that has a Beta of 1 means that if the broad stock market, for example FTSE 100, goes up or down 5% then so too will this share’s price increase or decrease by the same amount. Beta is, therefore, a factor that determines how volatile a stock is compared to the broad market. Let’s look at an example, as to use this factor we need to consider excess returns. This is the return of an asset above the risk-free rate. Stock A has a Beta of 0.5 and the expected return for the FTSE 100 is 5% with a risk-free rate of 0.50%. So the expected return for stock A would be equal to 5%, minus 0.50%, multiplied by 0.5 plus the risk-free rate; ((5-0.5)*0.5)+0.5 = 2.75%.

When the general stock market is doing well, it seems clear that holding defensive stocks will weaken the performance of a portfolio. However, investors hold them as stated above due to their lower volatility, but also for another reason: consistent and high dividend streams. Certain companies withhold paying dividends to control their share price; others simply pay low dividends partly for the same reason or for cash flow requirements, which arise mainly due to uncertainty. Defensive stocks routinely pay consistently high dividends as their income flow is usually reliable and steady throughout all cycles. These constant dividend yields also help offset reduced price performance in the bear market cycles. Holding a substantial portion of a stock portfolio in defensive stocks can help take the sting out of a bad year for stocks, as these shares often pay an average of around 5% in dividend yield.

Examples of Defensive stocks

Utility companies are probably the most well known of the defensive category. These companies are not very affected by the economic cycle; people always want to keep themselves warm or watch TV, so consumption changes tend to be relatively small. The National Grid, which is the UK’s largest electricity and gas company, offers a dividend yield of 5.2%.

The Pharmaceutical industry is another sector for defensive stocks. Consumers will tend to cut back on other expenses before the forfeit of looking after their health. GlaxoSmithkline, which makes some of the best known over the counter medicines, has a dividend yield of 6.6%.

General consumer goods is another sector that is considered as defensive; consumers can only save so much when going to the supermarket. Companies like Unilever, which have an extensive range of items from cleaning products to dairy products, has a dividend yield of 3.41%.

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Another less likely candidate perhaps, for defensive stocks are tobacco companies. True that, in most developed companies, there has been a large decline in tobacco consumption, but the trend is different in developing economies. As consumers in these economies become wealthier, they are also spending more on tobacco, where the anti-tobacco campaigns have not yet started. Imperial Tobacco and British American Tobacco both have dividend yields of 4.4%

Defensive Stock

What Is a Defensive Stock?

A defensive stock is a stock that provides consistent dividends and stable earnings regardless of the state of the overall stock market. There is a constant demand for their products, so defensive stocks tend to be more stable during the various phases of the business cycle. Defensive stocks should not be confused with defense stocks, which are the stocks of companies that manufacture things like weapons, ammunition, and fighter jets.

Key Takeaways

  • A defensive stock is a stock that provides consistent dividends and stable earnings regardless of the state of the overall stock market.
  • Well-established companies, such as Procter & Gamble, Johnson & Johnson, Philip Morris International, and Coca-Cola, are considered defensive stocks.
  • Defensive stocks offer the substantial benefit of similar long-term gains with lower risk than other stocks.
  • On the downside, the low volatility of defensive stocks often leads to smaller gains during bull markets and a cycle of mistiming the market.

Understanding Defensive Stocks

Investors seeking to protect their portfolios during a weakening economy or periods of high volatility may increase their exposure to defensive stocks. Well-established companies, such as Procter & Gamble (PG), Johnson & Johnson (JNJ), Philip Morris International (PM), and Coca-Cola (KO), are considered defensive stocks. In addition to strong cash flows, these companies have stable operations with the ability to weather weakening economic conditions. They also pay dividends, which can have the effect of cushioning a stock’s price during a market decline.

Defensive stocks are also less likely to face bankruptcy because of their relative strength during downturns.

In difficult times or if things are getting shaky, why would anyone even want to own a stock? Why not just go for the safety of a Treasury bill, which essentially has a risk-free rate of return? The answer is quite simply that fear and greed can often drive the markets. Defensive stocks accommodate greed by offering a higher dividend yield than can be made in low interest rate environments. They also alleviate fear because they are not as risky as regular stocks, and it usually takes a significant catastrophe to derail their business model. Investors also need to be aware that most investment managers have no choice but to own stocks. If they think times are going to be harder than usual, they will migrate toward defensive stocks.

Defensive stocks tend to perform better than the broader market during recessions. However, during an expansion phase, they tend to perform below the market. That is attributable to their low beta or market-related risk. Defensive stocks typically have betas of less than 1. To illustrate beta, consider a stock with a beta of 0.5. If the market drops 2% in a week, then we would expect the stock to lose only about 1%. On the other hand, a 2% price gain in the market during one week leads to an expected increase of just 1% for the defensive stock with a beta of 0.5.

Advantages of Defensive Stocks

Defensive stocks offer the substantial benefit of similar long-term gains with lower risk than other stocks. Defensive stocks as a group have a higher Sharpe ratio than the stock market as a whole. That is a strong argument that defensive stocks are objectively better investments than other stocks. Warren Buffett also became one of the greatest investors of all-time in part by focusing on defensive stocks. It is not necessary to take excessive risks to beat the market. In fact, limiting losses with defensive stocks may be more effective.

Disadvantages of Defensive Stocks

On the downside, the low volatility of defensive stocks often leads to smaller gains during bull markets and a cycle of mistiming the market. Unfortunately, many investors abandon defensive stocks out of frustration with underperformance late in a bull market, when they really need them most. After a downturn in the market, investors sometimes rush into defensive stocks, even though it is too late. These failed attempts at market timing using defensive stocks can significantly lower the rate of return for investors.

Examples of Defensive Stocks

Defensive stocks are also known as noncyclical stocks because they are not highly correlated with the business cycle. Below are a few types of defensive stocks.

Utilities

Water, gas, and electric utilities are examples of defensive stocks because people need them during all phases of the business cycle. Utility companies also get another benefit from a slower economic environment because interest rates tend to be lower.

Consumer Staples

Companies that produce or distribute consumer staples, which are goods people tend to buy out of necessity regardless of economic conditions, are generally thought to be defensive. They include food, beverages, hygiene products, tobacco, and certain household items. These companies generate steady cash flow and predictable earnings during strong and weak economies. Their stocks tend to outperform nondefensive or consumer cyclical stocks that sell discretionary products during weak economies while underperforming them in strong economies.

Healthcare Stocks

Shares of major pharmaceutical companies and medical device makers have historically been considered defensive stocks. After all, there will always be sick people in need of care. However, increased competition from new drugs and uncertainty surrounding regulations means that they aren’t as defensive as they once were.

Apartment REITs

Apartment real estate investment trusts (REITs) are also deemed defensive, as people always need shelter. When looking for defensive plays, steer clear of REITs that focus on ultra-high-end apartments. Also, avoid office building REITs or industrial park REITs, which could see defaults on leases rise when business slows.

What Is a Defensive Stock? Definition and Examples

Oct 2, 2020 4:20 PM EDT

Defensive stocks tend to reflect companies whose businesses are relatively immune to changes in economic conditions. These companies offer products and services that are needed in all economic conditions.

What Is a Defensive Stock?

Defensive stocks reflect companies whose earnings growth and performance have a low correlation to the economy. Revenue, profit and cash flow for companies whose stocks are considered to be defensive will remain stable regardless of the economy, as will the share price of the stock.

Defensive stocks tend to be in industries like utilities, personal care, healthcare and other consumer staples. The products and services offered by these companies usually have stable, if not growing demand, regardless of economic conditions.

Examples of Defensive Stocks

There are a number of different types of defensive stocks.

Utilities are one example. Water, gas and electric utilities represent companies whose services are vital. These are basic services that people need regardless of how the economy and the stock market are performing. These are companies that generally borrow a great deal of funds and they may actually benefit when the economy is weak since that is often accompanied by lower interest rates.

Consumer staples are another common defensive group of stocks. These are companies who produce and/or sell products such as tobacco, food, beverages, hygiene products and other household items that people need regardless of the state of the economy. The stocks of these types of companies will tend to outperform those of consumer cyclicals whose products and services are often discretionary in tough economic conditions. Consumers can often forgo purchases from these companies when the economy is slow.

Health care stocks are another group that has traditionally been considered as defensive. This group includes drug companies and manufacturers of medical devices. People get sick regardless of the economy and the demand for these types of products is not as sensitive to the economy as some others. In recent years, the character of many of these companies has changed and the group may not be as defensive as it once was. This is due to the onslaught of generic drugs and related products, as well as the uncertainties surrounding the regulatory environment for health care.

Defensive vs. Cyclical Stocks

Both defensive and cyclical stocks can have a place in an investor’s portfolio. It is important to understand the differences so they can have proper expectations about the potential performance of both types of stocks.

Cyclical stocks tends to follow the ups and downs of the economy. Their performance can be volatile over time.

Cyclical stocks tend to reflect products and services that consumers can and will forgo if the economy hits a rough patch. Many cyclical stocks are issued by companies that sell luxury goods and services. This might be high-end jewelry, expensive resorts or luxury automobiles. These are “nice-to-haves” that may become too pricey when people are concerned about whether they will have a job going forward.

Cyclical stocks tend to have a beta that is close to the market. A beta of 1.00 means that the stock will move roughly in lock-step with the market. A beta of greater than 1.00 means that the stock will move up or down at levels greater than the market. Defensive stocks, in contrast, will be less correlated to the market. Many defensive stocks will have a beta of less than 1.00. They tend to be less susceptible to movements in the stock market and to changes in economic conditions.

There is room in a well-diversified portfolio for both cyclical and defensive stocks. In fact, the proper mix for an investor’s individual situation can help them balance out the upside potential of cyclicals with the relative stability of defensive holdings.

Defensive Stocks for 2020 and Beyond

There are a number of top defensive stocks for investors to consider for 2020 and beyond. It should be noted that this list is in no way meant to be a recommendation nor should it be considered investment advice. Any decisions you make regarding whether to invest in these or any other stocks should be made based on your own analysis of your investing situation or in consultation with a qualified financial advisor.

NextEra Energy, Inc. (NEE) – Get Report operates a regulated utility, Florida Power & Light. Their site indicates they are the largest utility company in the world. The stock has gained 42.59% over the 12 months ending Sept. 27, 2020 compared to 27.57% for Morningstar’s Utilities-Regulated Electric category of stocks. Over the trailing 10 years, NEE’s stock has more than doubled the performance of the category. The current dividend yield is only 2.16%, but the actual dividend payout has increased from $2.90 per share in 2020 to a current annualized $5.00 per share based on the most recent quarterly payout.

Johnson & Johnson (JNJ) – Get Report is a broadly diversified healthcare company. Even though the company lost a recent judgement in an opioid case in Oklahoma, it’s expected that the appeals process will take a number of years to play out. In the end, the amount may be reduced and this will not have a material impact on the company’s financials. The stock’s returns have trailed their Morningstar category in recent years, but the company is recognized as having one of the most diverse revenue streams in the industry. Dividends have increased from $2.95 per share in 2020 to a current annualized rate of $3.80 per share. The current dividend yield is 2.95%.

The Kroger Co. (KR) – Get Report is the largest U.S. grocery chain. Besides selling groceries, some 82% of the location have a pharmacy on site as well. The performance of the company’s stock has been lackluster over the past several years, though it has seen a spike over the past three months. Its performance is a bit above that of it’s Morningstar category Grocery Stores for the trailing 10 years. The dividend has increased steadily from 34 cents per share in 2020 to 64 cents per share on a current annualized basis for a yield of 2.48%.

These stocks are just three examples of the many defensive stocks that might make sense for investor’s portfolios in 2020 and beyond.

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