What is a 'Defensive Stock'
A defensive stock is a stock that provides a constant dividend and stable earnings regardless of the state of the overall stock market. Because of the constant demand for their products, defensive stocks tend to remain stable during the various phases of the business cycle. A defensive stock should not be confused with a "defense stock," which refers to stock in companies that manufacture things like weapons, ammunition and fighter jets.
BREAKING DOWN 'Defensive Stock'During recessions, defensive stocks tend to perform better than the market. However, during an expansion phase, they tend to perform below the market. This is attributed to their low beta as defensive stocks typically have betas of less than one. To illustrate this phenomenon, consider a stock with a beta of 0.5. If the market is expected to drop 15%, and the existing risk-free rate is 3%, a defensive stock will only drop 9% (0.5 x (-15%-3%)). On the other hand, if the market is expected to increase 15%, with a risk-free rate of 3%, a defensive stock will only increase 6% (0.5 x (15%-3%)).
Examples of Defensive Stocks
The utility industry is an example of defensive stocks because, during all phases of the business cycle, people need gas and electricity. Investors tend to invest in defensive stocks if a market downturn is expected. However, if the market is expected to prosper, active investors will often choose stocks with higher betas in an attempt to maximize return. Defensive stocks are also known as "non-cyclical stocks" because they are not highly correlated with the business cycle.
Defensive stocks are characteristic of companies that produce or distribute consumer staples, which are goods people tend to buy out of necessity regardless of economic conditions. They include food, beverages, hygiene products, tobacco, medicines and certain household items. These companies generate steady cash flow and predictable earnings during strong and weak economies. As such, their stocks tend to outperform nondefensive or consumer cyclical stocks that sell discretionary products during weak economies, while underperforming them in strong economies.
The Role of Defensive Stocks in a Portfolio
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 Co., Johnson & Johnson, Phillip Morris International Inc. and Coca-Cola Co. are considered defensive stocks. In addition to strong cash flows, these companies have strong operations with the ability to weather weakening economic conditions. They also pay dividends, which can have the effect of cushioning the stock’s price during a market decline.
Defensive Stocks Have Been Steady Performers
As a sector, defensive stocks have consistently outperformed most sectors since 1962. Over a 10-year period through July 1, 2016, defensive stocks have returned a total of 128.16% versus 65.31% for the Standard & Poor’s 500 index. Over the last 20 years, since 1996, the worst three-year cycle for defensive stocks generated a negative 1% return compared with the broad stock market, which lost 16% during the same cycle.