What Is A Defensive Stock?
Defensive stocks, also called as Non-cyclical stocks, are the stocks which provide a constant dividend and stable earnings regardless of the state of the overall stock market. Because of the constant demand for their products, defensive stocks tend to remain stable during the various phases of the business cycle. In this article, we will discuss 5 key features of defensive stocks with examples.
5 Key Features of Defensive Stocks
What Are Defensive Stocks?
- If you invest in equity, you should have a clear picture of what defensive stocks are and how you can get benefited by investing in these stocks.
- Defensive or Non-cyclical stocks are the companies whose businesses are protected from changes in economic conditions. These companies offer products and services that are needed in all economic conditions.
- These stocks give stable kind of returns irrespective of varying market conditions.
- Defensive stocks reflect companies whose earnings growth and performance have a low correlation to the economy. Revenue, profit and cash flow for companies whose stocks are considered to be defensive will remain stable regardless of the economy, as will the share price of the stock.
- Defensive stocks tend to be in industries like utilities, personal care, healthcare and other consumer businesses.
- The products and services offered by these companies usually have stable, if not growing demand, regardless of economic conditions.
5 Key Features of Defensive Stocks
1. High Dividend Yield Stocks
- The most important feature of defensive stocks are high dividend yield stocks. Companies with rich cash flow but having limited options for future reinvestment comes under this head.
- Due to limitations for future expansion of business, these companies distribute dividends to its shareholders through its existing high cash flows.
- Generally, retained earnings that could be used for business expansions in near future are thus distributed in the form of high dividends.
- Examples : Coal India, Rural Electrification Corporation (REC), Power Finance Corporation Ltd
2. No Cyclicality in Demand
- Stocks with Non-cyclicality in demand are seen as defensive because, like utilities, FMCG etc.
- People will consume such utilities goods and services regardless of how markets are performing. Manufacturers of non-durable personal care items such as soap and toothpaste are popular defensive stocks.
- Whether times are good or bad, people still consume water, gas and electricity. Therefore if an economy appears to be heading into recession, investors will look to utilities to guard their portfolios against major losses.
3. Matured & Stable Businesses
- Some businesses are having a very matured and stable business models. For example, HDFC Bank, HUL etc.
- If a company has a strong advantage over its rivals, it will be able to protect its market share and profitability for longer.
- A strong and investable businesses thus taken as defensive stocks with high performance delivery in all type of market conditions.
4. Low PE Stocks
- Companies with low Price to Earnings Ratio. Their valuations are on lower side as compared with other businesses.
- Oil marketing companies like IOCL, BPCL, HPCL. There is no significant downside seen in these stocks when we look at their historical revenue as well as profit growths.
5. Low Beta Stocks
- Beta indicates the stock’s vulnerability or risk factor.
- Cyclical stocks tend to have a beta that is close to the market. A beta of 1 means that the stock will move roughly in lock-step with the market.
- A beta of greater than 1 means that the stock will move up or down at levels greater than the market.
- In contrast, Defensive stocks will be less correlated to the market. Defensive stocks have beta lesser than 1 which implies that they are less volatile. They tend to be less susceptible to movements in the stock market and to changes in economic conditions.
When One Should Choose to Invest in Defensive Stocks?
- When you don’t have a proper understanding of market conditions
- If Markets are volatile
- Picking defensive stocks suits your investment objectives
- If you are a risk-averse investor
- When you prefer a regular dividend income
- Cyclical stocks tend to outperform the market when the economy is in good shape and under-perform when the economy faces a downturn.
- On the other hand, defensive stocks give stable returns in all type of economic and market conditions.
- Picking of quality stocks which suit your investment objective is very essential. You have to regularly have a watch over your model portfolio to know which stocks are outperforming and which are under-performing.
- Based on the regular performance review of your portfolio, you can either add particular stocks or remove non-performing stocks to get overall better portfolio returns.