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What is a Defensive Stock?
Broadly speaking, most stocks march in line with the market, with their behavior matching the economic (or business) cycle, following the wide-scale fluctuations in production and activity that underlie the market’s long-term trends. Even though it is termed a business ”cycle,” periods of expansion (rapid economic growth) and decline (stagnation or contraction) rarely act in a predictable or mechanical pattern.
Regardless of the name tacked onto the market’s behavior, however, these trends are often gauged by the growth of the gross domestic product GDP. The latest recession started in late 2007, and ended in early 2009. Even though the period of significant decline of economic activity is behind us, an often volatile and ever-changing market sentiment has endured. Indeed, the long housing market downturn, coupled with high unemployment, and concerns regarding the European economy have kept investors on edge for several years.
Consequently, many investors have sought ways to mitigate the impact market volatility has on their portfolios. In such times, more conservative stocks often reign supreme. Many issues that fall into this category stand out in our index for their above-average Safety scores. These equities usually hold less risk, and possess low betas. These companies’ high scores for Stock Price Stability show that they are less easily swayed with the market averages. Often, these “safe” companies boast stellar finances (with little or no debt), adding to their overall investment appeal. Of course, size and scale help; equities with larger market caps tend to weather the storms better than smaller entities.
Because certain investment choices buck the trends of the broader market averages, they are deemed defensive; generally such companies reside in particular industries, and fare reasonably well, notwithstanding the economic backdrop. Indeed, companies with stable income streams become prime investment vehicles even as the economy stagnates or falters.
This isn’t to say that such businesses are entirely immune to the market’s troubles. Manufacturers are vulnerable to fluctuating input costs, regardless of whether they produce cars or toothpaste. Consumer and commercial spending is also affected by the economic backdrop forcing all companies to seek ways to maintain their market position, as they chase fewer dollars. Likewise, these holdings may well waver during volatile trading sessions.
Some industries, especially the more mature ones, tend to fare better than others in a contraction, however. For example, utilities are often deemed a safe havens. People still light and heat their homes, take showers and wash dishes, and make phone calls regardless of the economic climate. Utility stocks are inclined to outperform the market on a relative basis when overall conditions are soft. What’s more, this stock group usually stands out for dividend yield owing to the fact that the companies pay out most of their earnings to shareholders.
The defensiveness of Household Products is derived from the fact that the companies sell small-ticket items that are generally regarded as necessities. Even when customers cut back their discretionary purchases, they still brush their teeth and do laundry. Consumer goods are, therefore, purchased regularly regardless of the health of the general economy. Likewise, Cosmetic and Toiletries companies also do well in similar situations. People usually maintain their daily care regimen and typically do not defer purchases of the balms and creams used daily. And some healthcare companies like Pharmaceuticals , will continue to post modest gains, since patients generally still take medications even during times of economic distress.
Other mature industries are also praised for their defensive characteristics. The underlying demand for Food Processors rarely abates much even during business downturns, enabling the members of that group to register slow-growing, but steady income streams. Even the Fast Food purveyors in the Restaurant industry hold up nicely when times get tough. Though some consumers may not eat out as often, when they do, they usually favor restaurants that offer menus at lower price points.
In tougher times, certain consumers continue to splurge on products with recognizable names they associate with quality, while others tighten their pursestrings. In an effort to rein in their budgets, private label goods will often replace brand-name items. In the past few months, several manufactures have been catering to these cost-conscious consumers, offering generic goods, at a discount to branded alternatives.
Also, in tougher times, some consumers console themselves with their vices, which is why tobacco and alcohol stocks often fare well in more troubled times . Other vice stocks, however, like casino operators, do not normally perform as well since economic contractions upend leisure spending, hurting the hotels that house the slot machines and poker tables.
All told, defensive investment vehicles are normally a good shelter when the economy dips; at the same time, such stocks rarely peak during the business cycle’s highs. As such, investors usually turn to other groups with greater potential to maximize returns during the growth phase of the business cycle. Even so, these conservative holdings can help diversify one’s portfolio and help offset some of the damage a weak economy can cause.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.