Understanding Defensive Stocks

What is a Defensive Stock

Defensive stocks, also known as ‘non-cyclical stocks’ or ‘safe haven stocks’ comprise of companies that experience little variation in earnings and dividend payouts regardless of the state of the overall economy. Therefore, a defensive stock provides consistent dividends and stable earnings across market conditions. In general, this is because defensive stocks produce goods or services that are considered to be essential, meaning that the demand for these goods/services remain rather consistent.

It is important to note that holding defensive stocks provides no guarantee against negative returns; however, defensive stocks have historically weathered economic recessions better than cyclical stocks, which tend to track momentum of the underlying economy in the near-term.

What are the most defensive stocks

Defensive stock examples can be found within the utility, healthcare and consumer staples stock market sectors and generally exhibit the following characteristics:

• Strong balance sheets – Companies that maintain a low debt to equity ratio are better equipped to meet their debt repayments under difficult market conditions.
• Low beta – The ‘beta’ of a stock measures the correlation of the stock relative to the broader market. A beta close to 1 means that the stock performs similarly to the broader stock market and a low beta (close to 0) has less association with the broader market. Defensive stocks have beta values that are either close to 0 or have a negative beta.
• P/E Ratio – A price-to-earnings ratio or P/E ratio, is a well-known formula used to value a stock. A P/E ratio can also help to identify a defensive stock as they generally have a low price/earnings ratio. Stocks with lower P/E ratios are often indicative of defensive stocks because investors are not forced to pay a premium to own a stock with massive earnings growth potential. Instead, the ratio is low because earnings growth is steady, or close to zero, justifying a lower price relative to earnings.

For a full list of safe haven stocks for each of the three stock market sectors, read our article on safe haven stocks.

Defensive stock example

The stock market affects the economy in many ways and none more so than a severe recession or market crash. Market crashes like the Global Financial Crisis in 2008/2009 result in mass retrenchments, forced liquidations of large companies and government bailouts for sectors that pose a systemic threat should they fail.

During times of economic turbulence, investors attempt to shield themselves from assets that are declining in value and some of the worst performing assets tend to be cyclical stocks – stocks that are strongly correlated to the underlying economy. However, defensive stocks have often outperformed the overall equity market during market crashes with their desirable non-cyclical qualities.

An effective way to illustrate the tendency of defensive stocks to outperform during times of turbulence is to compare the performance of a defensive stock to its broader equity market’s performance over the same timeframe. For defensive stocks traded in the United States, you’ll want to look at the relative performance compared to one of the major indices, the Dow Jones Industrial Average, the S&P 500, or the NASDAQ 100.Below is a chart of the S&P 500 during the 2008/09 financial crisis. It is clear to see that the US equity market, as a whole, experienced a drastic decline. The S&P 500, due to its components, has a large weighing in cyclical stocks that suffered tremendously during this time – driving the index lower.

To the contrary, Gilead Sciences, a biopharmaceutical company, managed to endure the financial crisis and come out at similar levels at whichit entered. Their share price rose sharply, dropped sharply and then consolidated to leave the share price a lot better off than most cyclical stocks. Intuitively, this makes sense: consumers will demand healthcare and drug treatments regardless of the state of the economy. To this end, biopharmaceutical and healthcare stocks tend to be defensive stocks as they are counter-cyclical in nature.

It is crucial to note that defensive stocks do not necessarily rise in value during economic downturns. They may rise, hold value or even decline, nevertheless, they are desirable because they tend to outperform the wider stock market during crashes.