What Do We Mean By Defensive Stocks?
Defensive stocks are usually being added to investors’ portfolio in times of an economic downturn or market recessions. During all stages of a business cycle, these stocks can be seen performing well, even amid difficult economic conditions.
In this article, you will be familiarized with all the factors regarding defensive stock, including the sources of a defensive stock, its advantages and disadvantages, and the best time to buy them.
What is a Defensive Stock?
A defensive stock refers to a stock bought from a company that has kept steady earnings and consistent dividend payments despite the negative condition of the overall stock marketor even if there is an economic downturn. Whether the economy is rising or falling, the demand for the offerings of a defensive company will normally remain consistent.
Defensive stock is also being called as ‘non-cyclical’ companies, which the direct contraries of cyclical companies with earnings vary when the economic condition changes. Defensive stock includes food, tobacco, oil, and utilities. This stock is maintained even in difficult times because demand does not decline radically as it may in other sectors. However, this stock tends to straggle from the rest of the market during economic expansion because demand does not increase as radically in an upswing.
A defensive stock should not be confused with a ‘defense stock,’ which refers to stock in companies that creates things like weapons, ammunition, and fighter jets.See also Looking Into Economic Indicators
How Defensive Stocks Work?
Defensive stocks can be spotted in companies that manufacture or offer products and/or services that are essential to consumers’ daily lives, such as food, utilities, oil, etc. In other words, products that are regarded as basic necessities that we have as human beings. The demand for these products can remain steady irrespective of the fluctuations in price.
Examples of defensive include companies belonging to the following market sectors:
• Utilities: including electricity, natural gas, propane, heating fuel, oil, and water. At one time, this list would have included telephone and cable television companies, but competition has removed the ‘captive’ customers these companies once enjoyed when they owned franchise territories.
• Food and Beverages: including producers of food products, beverages, including those that contain alcohol, and sometimes fast food restaurants that compete for customers based on the price of their offerings.
• Healthcare: including household goods that are quickly consumed such as soap, detergent, deodorant, and toothpaste. These are essential household products that most consumers will buy despite the money is tight.
Defensive stocks are well-known for their ability to withstand economic depressions but it is important to remember that they could also disregard economic upswings. In short, they outperform the market during recessions and underperform it during expansions.See also Learning About Tech Stocks
Advantages and Disadvantages of Defensive Stocks
Through the purchase of defensive stocks, investors can have a conservative portfolio, which should produce above-average returns during a recession. The profitability of these stocks will hold up during these difficult economic times because the demand for the products or services of these companies is relatively inelastic.
Similar attributes that let these companies produce above-average returns during recessions will also result in below-average returns when an economy rebounds. This is the biggest downside of investing in a non-cyclical stock. They neither dip as fast as other stocks during a bear market nor increase as fast as other stocks during a bull market.
When to Consider Buying Defensive Stocks?
The best time to purchase non-cyclical stocks is just before the economy enters a recession. That is the main reason why they are denoted as defensive stocks. They can give investors a safety net during hard times. Once the market is deeply rooted in a bear market, it is often too late to invest in a defensive stock.
On one hand, the worst time to invest in this class of stocks is at the start of a bull market. With a beta of less than one, these stocks can be expected to return less-than-average profits when the rest of the stock market is soaring higher.See also Learn When to Sell Stocks