What Is a Defensive Stock?
A defensive stock provides consistent dividends and stable earnings regardless of the overall state of the stock market. There’s a constant demand for these companies’ products, making them more stable during various phases of the business cycle.
Defensive stocks shouldn’t 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 to be defensive stocks.
- Defensive stocks offer the substantial benefit of similar long-term gains with lower risk than other stocks.
- The low volatility of defensive stocks often leads to smaller gains during bull markets but provides stability during downturns.
Understanding Defensive Stocks
Investors who seek 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, Johnson & Johnson, Philip Morris International, and Coca-Cola, are considered to be defensive stocks. These companies have strong cash flows and stable operations with the ability to weather weakening economic conditions. They also pay dividends, which can cushion a stock’s price during a market decline. Defensive stocks are less likely to face bankruptcy due to their relative strength during downturns.
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’re not as risky as regular stocks. It usually takes a significant catastrophe to derail their business model. Most investment managers have no choice but to own stocks. If they think times are going to be harder, they’ll migrate toward defensive stocks.
Defensive stocks tend to perform better than the broader market during recessions but often perform below the market during an expansion phase due to their low beta or market-related risk. Defensive stocks typically have betas of less than 1.0. For instance, a stock with a beta of 0.5 might be expected to lose only about 1% if the market drops 2% in a week but would gain just 1% in a week where the market rises 2%.
Advantages of Defensive Stocks
Defensive stocks offer substantial benefits like similar long-term gains with lower risk than other stocks. Collectively, they have a higher Sharpe ratio than the stock market as a whole, making them objectively better investments than other stocks according to many metrics.
Warren Buffett became one of the greatest investors of all time in part by focusing on defensive stocks. Limiting losses with defensive stocks can often be more effective than seeking substantial but risky gains.
Disadvantages of Defensive Stocks
On the downside, the low volatility of defensive stocks often leads to smaller gains during bull markets and can result in investors mistiming the market. Many investors abandon defensive stocks out of frustration after extended bull market underperformance, just when they might need them the most.
Rushing into defensive stocks after a market downturn can result in suboptimal returns, particularly if done too late.
Examples of Defensive Stocks
Defensive stocks are also known as noncyclical stocks because they’re not highly correlated with the business cycle. Here are a few types of defensive stocks:
Utilities
Water, gas, and electric utilities are classic examples of defensive stocks because people need them during all phases of the business cycle. These businesses also benefit from lower interest rates in slower economic environments.
Consumer Staples
Companies that produce or distribute consumer staples are generally considered defensive. These include food, beverages, hygiene products, tobacco, and certain household items. Consumers will continue to buy these necessities regardless of economic conditions, offering companies steady cash flows and predictable earnings during both strong and weak economies.
Healthcare Stocks
Shares of major pharmaceutical companies and medical device makers have traditionally been viewed as defensive stocks because there will always be people in need of healthcare. Nevertheless, they are facing increased competition from new drugs and regulatory uncertainties.
Apartment REITs
Apartment real estate investment trusts (REITs) are deemed defensive because people always require housing. However, steer clear of REITs focusing on ultra-high-end apartments or those with exposure to office buildings and industrial parks, as these can suffer during economic downturns.
What Are Dividends and How Are They Paid?
Dividends are a shareholder’s portion of a company’s earnings, often paid quarterly in cash or additional stock. Companies may cut dividends to very low levels or eliminate them during financially challenging quarters.
When Does a Poor Economy Become a Recession?
An official U.S. recession is declared by the National Bureau of Economic Research (NBER) and is usually confirmed after two subsequent quarters of negative gross domestic product growth rates.
Why Are Treasury Bills Considered Risk-Free?
Treasury bills, or T-bills, are issued by the United States Department of the Treasury. Purchasing a T-bill is essentially loaning money to the U.S. government, which is considered risk-free because the government backs these loans entirely.
The Bottom Line
Defensive stocks provide stable, consistent earnings and dividends and are less susceptible to market fluctuations. Though less risky, they also offer lower gains, particularly during bull markets. It’s advisable to talk to an investment advisor about including defensive stocks as part of a balanced portfolio.
Related Terms: noncyclical stocks, Treasury Bills, dividends, recessions, beta.
References
- BusinessKnowledgeSource.com. “What Does It Mean If My Stock Has a Beta of Less Than 1?”
- Morningstar. “What Is the Sharpe Ratio?”
- Ally Financial Inc. “What Are Dividends and How Do They Work?”
- CFI Education. “Recession”.
- CFI Education. “Treasury Bills (T-Bills)”.
