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.
Defensive Stock Explained
Defensive stocks tend to perform better than the broader market during recessions. However, during an expansion phase, they tend to perform below the market. This is attributed to their low beta, or relative risk and performance to the market. Defensive stocks typically have betas of less than 1. 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%)].
Investors tend to invest in low-beta, 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.
Examples of Defensive Stocks
Defensive stocks are also known as "non-cyclical stocks," because they are not highly correlated with the business cycle. Below are a few types of defensive stocks.
Water, gas, and electric utilities are an example of defensive stocks because people need them during all phases of the business cycle. Utility companies also are thought of as benefiting from slower economic environments because interest rates tend to be lower and their competition to borrow funds is much less.
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. As such, their stocks tend to outperform non-defensive or consumer cyclical stocks that sell discretionary products during weak economies, while underperforming them in strong economies.
Health Care Stocks
Shares of major pharmaceutical companies and medical device makers have historically been considered defensive stocks, as there will always be sick people in need of care. But increased competition from new branded and generic drugs, and uncertainty surrounding drug price regulation, means they aren't as defensive as they once were.
Apartment real estate investment trusts (REITs) are also deemed defensive, as people always need shelter. Plus, REITs are required to pay a minimum of 90% of their taxable income in the form of shareholder dividends each year. When looking for defensive plays, steer clear of REITs that focus on ultra-high-end apartments, though, as well as office building REITs or industrial park REITs, which could see defaults on leases rise when business slows.
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, Johnson & Johnson, Philip Morris International, and Coca-Cola 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 a stock’s price during a market decline.
Some may ask, "If times are hard 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 major catastrophe to derail their business model. It should also be known that most investment managers have no choice but to own stocks, and if they think times are going to be harder than normal, they will migrate toward defensive stocks.