What Is a Defensive Company?
A defensive company is a corporation whose sales and earnings remain relatively stable during both economic upturns and downturns. Defensive companies tend to make products or services that are essential to consumers. These products are likely to be purchased whether the economy is booming or in a recession. Defensive firms tend to have long histories of surviving economic downturns.
At the opposite end of the spectrum are companies that rely heavily on the strength of the economy. These include luxury good companies, which tend to do well when consumers are financially successful and feel confident.
- A defensive company is a corporation whose sales and earnings remain relatively stable during both economic upturns and downturns.
- Defensive companies are found mostly in specific sectors and industries.
- Most of the advantages of defensive companies are direct results of their stability.
- In many cases, their defensive nature prevents these firms from expanding rapidly.
Understanding Defensive Companies
Defensive companies are found mostly in specific sectors and industries. One can speak of defensive industries as well as defensive firms. Companies in the utility industry, for example, are defensive because consumer demand does not decline as much during downturns. Consumers need electricity, water, heating, and air conditioning, whether the economy is in a recession or not. The other primary defensive industries are consumer staples and healthcare.
Defensive companies may lag behind other firms during periods of economic expansion due to the stability of demand for their products and services. The surge in demand for discretionary goods during economic booms can sometimes detract from the profits of defensive companies.
The relative outperformance of defensive companies during economic downturns forms the basis of sector rotation strategies. In these strategies, investors overweight and underweight sectors as the economy proceeds through the business cycle.
Investing in defensive companies is usually a more profitable strategy for discouraged investors than abandoning the stock market.
Advantages of Defensive Companies
Defensive companies have attractive features for investors, employees, consumers, and national economies. Most of the advantages of defensive companies are direct results of their stability.
Investing in defensive businesses often provides long-run returns similar to other firms, but with less volatility. More importantly for long-term stock investors, defensive companies are less likely to go bankrupt because of their relative strength during recessions. Warren Buffett often invests in defensive companies, such as Coca-Cola (KO).
Employees of defensive companies have the same opportunities for promotions and higher salaries as employees of other large companies. However, they are less likely to lose their jobs during recessions because of the relative stability of their employers.
Consumers also benefit from long-term familiarity with defensive companies. Many defensive firms have been producing the same products for generations. Some of their products are found all over the world. When a consumer goes to McDonald's, they know what to expect.
Finally, having a large number of firms in defensive industries makes national economies more stable. The legendary stability of Switzerland is due in part to defensive companies like Nestlé.
Disadvantages of Defensive Companies
Defensive companies also have a few drawbacks. In many cases, their defensive nature prevents these firms from expanding rapidly. In the utility industry, they are often bound by more regulations than other businesses. In other cases, the size and influence of a particular defensive firm caused the government to place restrictions on its activities. For example, AT&T was not allowed to expand outside of the telephone business for several decades.