Introduction
The word ‘defensive’ may not be the most appealing term for investors seeking potential stocks to invest in. However, defensive stocks have proven to be critically important during market volatility and crashes. These types of stocks have the ability to shield investors during financial recessions or market crashes due to their diversification benefits. In this article, we will explore what defensive stocks are, their usefulness, and how traders and investors can benefit from trading them. Additionally, we recommend that novice stock traders read about stock market basics to gain a better understanding of the world of stock trading.
What is a Defensive Stock
Defensive stocks, also known as ‘non-cyclical stocks’ or ‘safe haven stocks’, consist of companies that experience minimal variation in earnings and dividend payouts regardless of the state of the overall economy. These stocks provide consistent dividends and stable earnings across various market conditions. The reason behind their consistency is that defensive stocks typically involve the production of goods or services that are considered essential, leading to a relatively stable demand for these goods/services. It’s important to note that although holding defensive stocks doesn’t guarantee against negative returns, they have historically weathered economic recessions better than cyclical stocks that closely track the momentum of the underlying economy in the short term.
Characteristics of Defensive Stocks
Defensive stock examples can be found within the utility, healthcare, and consumer staples sectors of the stock market. These sectors generally exhibit the following characteristics:
- Strong balance sheets: Companies with low debt to equity ratios are better equipped to meet their debt repayments even under challenging market conditions.
- Low beta: Beta is a measure of a stock’s correlation with the broader market. Defensive stocks usually have beta values close to 0 or even negative, indicating less association with the broader market.
- P/E ratio: The price-to-earnings ratio (P/E ratio) helps evaluate a stock’s value. Defensive stocks tend to have low P/E ratios, signaling steady or minimal earnings growth. This lower ratio justifies a reduced price relative to earnings as investors do not need to pay a premium for massive earnings growth potential.
For a comprehensive list of safe haven stocks within each sector, please refer to our article on safe haven stocks.
Defensive Stock Example
The stock market’s impact on the economy is profound, especially during severe recessions or market crashes. Such events often result in mass layoffs, forced liquidations, and government bailouts for sectors that pose systemic threats. When the economy is experiencing turbulence, investors typically attempt to shield themselves from declining assets, and cyclical stocks are often among the worst performers. On the other hand, defensive stocks have consistently outperformed the overall equity market during market crashes due to their desirable non-cyclical qualities.
To illustrate the tendency of defensive stocks to outperform during turbulent times, let’s compare the performance of a defensive stock to that of its broader equity market over the same timeframe. For instance, during the 2008/09 financial crisis, the S&P 500 experienced a significant decline due to its substantial exposure to cyclical stocks. However, Gilead Sciences, a biopharmaceutical company, managed to endure the financial crisis and maintain its share price at similar levels. The demand for healthcare and drug treatments remained strong, irrespective of the state of the economy. This exemplifies biopharmaceutical and healthcare stocks as defensive stocks, as they defy the cyclical nature of the markets.
Other Defensive Assets
Defensive assets are not limited to the equity market; they also extend to other markets such as forex, commodities, and bonds.
Safe-Haven Currencies
Currencies considered safe havens tend to be negatively correlated with stocks during market crashes. Examples of such safe haven currencies include the US Dollar, Euro, Japanese Yen, and Swiss Franc. These currencies are characterized by current account surpluses, strong financial systems, low government debt-to-GDP ratios, stable economic growth, and sufficient liquidity. It’s worth noting that safe-haven currencies may not possess all these characteristics, but they typically benefit from most of them.
Defensive Commodities
Gold is widely recognized as a safe-haven metal due to its constant demand for purposes such as jewelry and industrial uses. Unlike currencies, the supply of gold is naturally limited, which sets it apart from the potential inflation risks associated with increasing money supply. Gold has played a significant role in monetary affairs throughout human economic history.
US Government Bonds
During stock market declines, investors often turn to US government bonds as a means to transfer funds from risky assets to more stable ones. Government bonds are typically low-return investment vehicles backed by the US government. As they are considered among the safest bonds in the world, these bonds benefit from the strength and stability of the US economy.
Defensive Stocks FAQ Section
Are defensive stocks only beneficial during recessions?
Defensive stocks have historically outperformed cyclical stocks during recessions. However, they also provide value during economic upswings. In fact, defensive stocks are relatively inexpensive, allowing investors to acquire them at favorable prices while cyclical stocks are performing well. Additionally, defensive stocks offer the benefit of diversifying a stock portfolio, even during economic booms.