What is a defensive stock?
Defensive action is one that provides a constant dividend and a stable profit regardless of the state of the overall stock market. Due to the constant demand for their products, defensive stocks tend to remain stable during the various phases of the economic cycle. Defensive stock should not be confused with “defense stock”, which refers to stock in companies that manufacture things like weapons, ammunition and fighter jets.
Explanation of the defensive stock
Defensive stocks tend to outperform the overall 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 in the market. Defensive actions generally have beta less than 1. To illustrate this phenomenon, consider an action with a beta of 0.5. If the market should fall by 15% and the existing risk-free rate is 3%, a defensive title will only fall by 9% [0.5 x (-15%-3%)]. On the other hand, if the market should increase by 15%, with a risk-free rate of 3%, a defensive title will only increase by 6% [0.5 x (15%-3%)].
Investors tend to invest in defensive stocks with low beta if a market downturn is expected. However, if the market is expected to thrive, active investors will often choose stocks with higher betas to maximize returns.
Examples of defensive actions
Defensive actions are also called “non-cyclical actions” because they are not strongly correlated with the economic cycle. Here are some types of defensive actions.
Water, gas and electricity services are an example of defensive stocks because people need them during all phases of the economic cycle. Utility companies are also considered to benefit from a slower economic environment, as interest rates tend to be lower and their competition for borrowing funds is much less.
Companies that produce or distribute everyday goods, which are goods that people buy out of necessity regardless of economic conditions, are generally considered defensive. They include food, drink, hygiene products, tobacco and certain household items. These companies generate stable cash flows and predictable profits during strong and weak economies. As such, their stocks tend to outperform non-defensive or cyclical consumer stocks that sell discretionary products during weak economies, while underperforming them in strong economies.
The actions of large pharmaceutical companies and medical device manufacturers have always been viewed as defensive actions, as there will always be sick people in need of care. But increased competition from new brand and generic drugs and the uncertainty surrounding the regulation of drug prices means that they are no longer as defensive as they once were.
REIT of apartments
Real estate investment trusts (REITs) are also considered defensive, because people still need shelter. In addition, REITs must pay at least 90% of their taxable income in the form of dividends to shareholders each year. When looking for defensive games, avoid REITs which focus on ultra high-end apartments, as well as office building REITs or industrial park REITs, which could see defaults increase in the event of a slowdown in payments. business.
The role of defensive stocks in a portfolio
Investors looking to protect their portfolios in times of economic downturn or in times 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 actions. In addition to strong cash flows, these companies have strong businesses with the ability to withstand weaker economic conditions. They also pay dividends, which can dampen the stock price during a market downturn.
Some may ask, “If times are tough or things get volatile, why would anyone even want to own an action?” Why not just opt for the security of a Treasury bill, which basically has a risk-free rate of return? The answer is simply that fear and greed can often drive the markets. Defensive stocks respond to greed by providing a higher dividend yield than can be achieved in low interest rate environments. They also alleviate fear, as they are not as risky as common stocks, and it usually takes a major disaster to derail their business model. Also be aware that most investment managers have no choice but to hold stocks, and if they think times are going to be harder than normal, they will migrate to defensive stocks.