There are various strategies and options available to protect and grow your capital in the market. One such approach revolves around defensive stocks, a word that is frequently used but needs to be understood better. From utilities to consumer staples, defensive stocks showcase resilience across several sectors, highlighting their long-term appeal to investors seeking stability.
Let us take a look at the meaning of defensive stocks, understand their advantages, and how they fit into an investor's portfolio.
What is a defensive stock
Defensive stocks are shares that provide stable returns through consistent dividends, regardless of fluctuations in the overall stock market. These stocks belong to industries producing products that remain in demand, irrespective of market conditions. Due to the constant demand for their products, defensive stocks tend to remain relatively stable during periods of economic volatility. They offer the substantial benefit of long-term gains against comparatively lower risks than other stocks. However, due to the low volatility of these stocks, the gains during bull markets tend to be modest.
Also read: What is the difference between shares and stocks?
Features of defensive stocks
- Stability: Defensive stocks are known for stability, providing investors with a sense of security despite market volatility.
- Consistent dividends: These stocks frequently pay a consistent dividend, providing investors with a continuous income stream.
- Low volatility: Their low beta indicates a lower sensitivity to market movements, making them a safer choice during uncertain times.
Industries covered by defensive stocks
Now that we have covered the meaning of defensive stocks, it is time to focus on the industries these stocks belong to. Defensive stocks usually belong to industries that deal with necessary goods and services. Since necessary goods are deemed as ‘essentials’ by consumers, the demand for these goods is relatively inelastic. In other words, the demand does not fluctuate with fluctuating market conditions. Here’s a list of industries covered by defensive stocks:
1. Utilities
Utilities like gas, water, and electricity are some of the basic requirements for living. The demand for these necessities tends to remain unchanged because people require them during all phases of a business cycle. In other words, changes in the market condition have little to no bearing on the demand for utilities. Moreover, during economic slow-downs, these utility companies take advantage of borrowing funds at a low interest rate.
2. Healthcare
Shares of top pharmaceutical companies and manufacturers of medical devices also fall within the ambit of defensive stocks. These stocks are considered non-cyclical since there will always be people in need of medical aid and care regardless of the economic condition. However, today, the advent of new drugs and uncertainty surrounding regulations have these stocks less defensive.
3. Consumer staples
Companies involved in the manufacturing or distribution of consumer staples are generally thought to be defensive. Consumer staples include certain goods like food, beverages, hygiene products, and household items that people purchase out of necessity. These stocks generally outperform non-defensive consumer goods stocks selling discretionary products during periods of economic downturns but tend to underperform during bull markets.
Identifying defensive stocks
Beta is an important indicator for finding defensive stocks. It indicates how much a stock may rise or fall relative to the overall stock market. With lower values indicating less volatility relative to the overall market. Furthermore, defensive stocks are often found in industries that provide essential goods and services, such as utilities and consumer staples. Defensive stocks include utilities such as electricity and water, as well as home necessities such as food and personal care items.
Why invest in defensive stocks?
Adding defensive stocks to your investment portfolio is a prudent move to protect your invested capital and reduce risk. Here’s why adding defensive stocks to your portfolio makes sense:
1. Portfolio stability
Defensive stocks act as a protective shield to your investment portfolio, creating a hedge against portfolio volatility. During periods of economic downturns, investors can rely on their defensive stocks to reduce losses.
2. Ideal for novice investors
For novice investors with limited market knowledge, defensive stocks serve as a good starting point. These stocks allow new investors to acquire better market understanding without exposing themselves to the enhanced risks associated with aggressive investing. Apart from beginners, defensive stocks are also suitable options for risk-averse investors looking for risk-balanced returns.
3. Steady revenue stream
Defensive stocks offer a steady and certain income through dividend payments. These stocks generally offer good dividend payments in both bull and bear markets. This steady income stream becomes crucial in bear markets, helping the investor survive the economic downturn.
Also read: How to invest in the stock market?
Practical example
The stock market witnessed intense volatility, with significant price drops leading to investor panic due to the COVID-19 pandemic. As major benchmark indices like the Sensex and Nifty50 experienced the biggest falls, investors turned to defensive stocks as portfolio safe-havens.
Stocks of Britannia Industries is a prime example of a defensive stock that offered steady returns during the pandemic. Britannia Industries is a leading FMCG company in India, manufacturing a range of biscuits, rusks, dairy products, and cakes. The top-performing consumer goods stock rallied, clocking a fresh 52-week high of Rs. 3,479.55 on 2nd June 2020. Comparatively, stock prices of SpiceJet, a top performer in the aviation sector, decreased to almost half by July 2020 due to the COVID pandemic travel restrictions.
Factors to consider before investing in defensive stocks
When considering investing in defensive stocks, it is important to evaluate several key factors to ensure that these investments align with your financial goals and risk tolerance. Here are the main factors to consider:
1. Historical performance evaluation:
Before investing in defensive stocks, it is important to research the company's previous performance. Analyse how the stock has fared throughout previous economic downturns since this might provide insight into its durability and stability.
2. Dividend yield analysis:
Pay attention to the dividend yield provided by the defensive stock. This stat accounts for a large portion of the investment's profits, delivering a consistent revenue stream despite market swings.
3. Sector dynamics assessment:
Conduct a detailed examination of the sector to which the defensive stock belongs. Evaluate its growth potential and exposure to economic cycles, ensuring that they are in line with your investment objectives and risk tolerance.
4. Company fundamentals review:
Assess the company's financial health, managerial quality, and competitive position. Strong fundamentals provide investors confidence in the defensive stock's long-term survival and success.
5. Beta examination:
Determine the beta value of the defensive stock, which reflects its volatility in relation to the overall market. A low beta suggests a lower sensitivity to market volatility, which is consistent with the stock's defensive character.
6. Market conditions consideration:
Consider the current market circumstances and economic forecast before making investing choices. Defensive stocks prosper during periods of economic uncertainty, providing investors with steadiness and downside protection.
Advantages
Defensive stocks offer several key benefits that can make them a valuable component of an investment portfolio:
1. Stability:
Defensive stocks provide a sense of security amidst the volatility of financial markets. Their durability provides constant performance despite economic volatility.
2. Downside protection:
Investing in defensive stocks safeguards investors from market downturns. These equities tend to perform well during economic downturns, minimising the effect of negative market sentiment on portfolio value.
3. Regular dividend payouts:
Many defensive stocks have a history of paying dividends regularly, providing investors with a steady income stream. This constant dividend income acts as a buffer, increasing total investment returns.
4. Diversification benefits:
Including defensive stocks in an investing portfolio increases diversity while lowering total portfolio risk. Their non-correlation with cyclical stocks enables a balanced allocation that maximises risk-adjusted returns.
Disadvantages
Despite their benefits, defensive stocks also come with several drawbacks that investors should consider:
1. Limited growth potential:
Defensive stocks, which sometimes represent mature companies in established industries, may lack the spectacular growth potential of more dynamic counterparts. This slow growth trajectory may discourage expectations for significant capital appreciation.
2. Potential overvaluation:
Because of their reputation for steadiness, defensive stocks may become overvalued during economic slowdowns. This overvaluation puts investors at risk of receiving inadequate long-term returns.
3. Regulatory and sector risks:
Certain sectors, such as utilities and healthcare, are subject to regulatory changes and industry-specific risks. Defensive stocks in these industries may experience problems due to regulatory changes or technological disruptions, affecting their performance.
4. Vulnerability to market sentiment:
Despite their defensive attributes, defensive stocks are sensitive to market sentiment. Negative market sentiment or unanticipated events might cause downturns in their performance, reducing investor returns.
Difference between defensive and cyclical stocks
Defensive stocks differ from non-cyclical stocks in the following ways:
1. Performance dynamics
- Defensive stocks maintain stable performance despite economic volatility.
- Cyclical stocks, on the other hand, are more subject to economic cycles, and their performance fluctuates in response to economic conditions.
2. Dividend payments
- Defensive stocks often produce consistent dividend distributions, giving investors a steady income stream.
- Cyclical stocks may have varying dividend payouts, which reflect the cyclical nature of their profits and market situations.
3. Sector composition
- Defensive stocks are typically found in sectors that provide basic or important services, such as utilities and consumer staples.
- Cyclical equities are typically found in industries prone to economic cycles, such as manufacturing and construction.
4. Risk exposure
- Defensive stocks provide downside protection and stability, reducing risk during economic downturns.
- Cyclical stocks are more susceptible to economic swings, and their performance is directly linked to the business cycle.
5. Investment strategy
- Defensive stocks are ideal for conservative investment strategies since they provide stability and income.
- Cyclical stocks appeal to aggressive investors seeking to profit from economic upswings and growth prospects, which correspond with more aggressive investment strategies.
Conclusion
Defensive stocks can provide you security despite the turbulence of financial markets, thanks to their steady performance and reliable dividend payments. However, careful analysis of aspects such as past performance and industry dynamics is required before including defensive stocks in your investment portfolio.
