Defensive Stock Definition
A Defensive Stock is a stock that provides steady growth and earnings to the investors in the form of dividends irrespective of the state of the economy as it has a low correlation with the overall stock market/economy and is therefore insulated from changing business cycles.Business Cycles.The business cycle represents the expansion and contraction of the economy that occurs due to ups and downs in the gross domestic product (GDP) of a country. It is experienced over the long term and goes parallel with the natural growth rate. Examples of Defensive sector stocks include utilities, consumer durables, pharmaceuticals, and real estate.
List of Defensive Sector Stock
These stocks are hedged from the uncertainty factors in the business cycles of the market and economy. The following is the list of defensive sector stocks.
#1 – Domestic Utilities
Power, Gas, and Water are generic examples of defensive stocks as it is a basic necessity to people of any economic class or background as they are required by the people during any phase of an economic cycle. Utility companies gain from slower business cycles as borrowing rates, or the cost of capital tends to be lower during an economic slowdown.
#2 – Consumer Durables
A business involved in the manufacture or distribution of fast-moving consumer durables like food and drinks, clothing, health products which consumers purchase out of necessity irrespective of the economic cycle. These companies generate stable revenues during both robust and slow economic cycles.
#3 – Pharmaceutical or Medical Stocks
Shares of pharmaceutical or life science companies perform well in any economic cycle as there will be sick people requiring these drugs or medicines to fight life-threatening diseases. But due to new companies entering the Drug and medicine manufacturing market and the absence of drug price control bodies means they may no longer be defensive as before.
#4 – Real Estate or Property Market
The companies involved in building houses and apartments for retail consumption show an ever-increasing demand as people require shelter as a basic necessity irrespective of the economic cycle. Besides, real estate companies need to pay a minimum amount of money as Dividends to its shareholders out of their taxable profits as a statutory requirement. While seeking these stocks that keep aside companies dealing in high-end flats, office building, or technology parks, which may see non-payment of Leases when the economy or business is low.
Example of Defensive Stock
Consider a stock with a Beta 0.6. If the market is expected to drop 20% and the risk-free rate is 5%, the drop in the defensive stock will be [0.6*(-20%-5%)] = 15%. On the other side, if the market is expected to rise by 10% with a risk-free rate of 5%, a defensive stock will increase by [0.6*(10%-5%)] = 3%. Investors generally invest in low beta stocks when they expect the market will fall, whereas, in times when the market is expected to be high, investors seek high beta stocks to maximize their returns.
The greatest advantage an investor gains through defensive stocks is a balanced portfolio of low beta stocks coupled with some non-defensive high beta stocks to give him steady and safe returns over a period of time as these stocks balance the risk of a portfolio of stocks comprising of high and low beta stocks making a conservative portfolio.
The portfolio with defensive stocks provides steady returns, even in a slow-growing economy. The returns from these stocks will remain stable even during recessionary economic conditions as the demand for the goods or services of these companies will remain inelastic regardless of the economic conditions. That means that even when the economy is bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market. or sluggish, there will be a steady market demand for products manufactured or services provided by defensive stocks companies. The ideal time to buy such stocks will be during an economic downturn, and the worst time to buy would be during an economic boom or a bull marketBull MarketA bull market occurs when many stock prices rise 20% from a recent low for an extended period. In addition, it is expected that prices will continue to go up. The bullish phase marks an increase in investor's confidence, corporate profits, reduced unemployment, and an improving GDP. as the beta factor for these stocks tends to less than one giving below-average returns when the market is high.
- #1 – Defensive Stocks can Slide Low – They can slide up or down like any other stocks. The reasons behind their slide being geopolitical, economic, or industry factors. Interestingly, these stocks are not hit hard in a declining market as a steady dividend flow in such times acts as a support to defensive stocks. Therefore, as compared to other stocks, defensive stocks are less affected by economic slowdowns.
- #2 – Interest Rate Factor – Defensive Stocks may be sensitive to rising interest rates. When interest rates rise, other securities like corporate bonds, Treasury securities, Bank deposits are more profitable. When defensive stocks yield 4%, and the interest rate rises up to 6% or 7%, one may consider selling defensive stocks. As more investors start selling their stocks, the prices for them start falling. Rising interest rates may deplete the company’s resources and affects its earnings as it pays more interest and may pay lesser dividends as it Profit after interest and taxes take a fall.
- #3 – The Inflation Factor – Even if the companies raise their dividend rates, although many don’t, the rise may be small. If income is of prime concern, then the investor needs to be aware. Rising inflation causes a concern when the investor is receiving the same level of dividend year on year as rising inflation reduces the value of dividend received as the nominal returns on investments starts falling.
Interestingly, dividends perform better than fixed income bearing bonds and investments. Moreover, defensive stocks companies provide a greater return on investment (ROI) than the rate of inflation as demand for the goods and services of defensive stock companies always remain stable.
Although the return on investment may be low during a bullish market for defensive stocks, they provide a necessary hedge against a slide in returns in bearish markets as the demand for companies stocks providing defensive goods and services remains relatively stable in any given market condition. It not only provides a steady income stream but also provides a conservative portfolio of stocks with diversified risks and returns.
This has been a guide to Defensive Stock and its definition. Here we discuss the list of defensive sector stocks along with an example, advantages and disadvantages. You can learn more from the following articles –