Understanding Defensive Stocks, Pros & Cons, and Examples

What Is a Defensive Stock?

A defensive stock provides consistent dividends and stable earnings regardless of the overall state of the stock market. There's a constant demand for these companies' products so they tend to be more stable during the various phases of the business cycle.

Defensive stocks shouldn't be confused with defense stocks, which are the stocks of companies that manufacture things like weapons, ammunition, and fighter jets.

Understanding Defensive Stocks

Investors who seek to protect their portfolios during a weakening economy or periods of high volatility may increase their exposure to defensive stocks.

Well-established companies such as Procter & Gamble (PG), Johnson & Johnson (JNJ), Philip Morris International (PM), and Coca-Cola (KO), are considered to be defensive stocks. These companies have strong cash flows and stable operations with the ability to weather weakening economic conditions. They also pay dividends and this can have the effect of cushioning a stock's price during a market decline.

Why would anyone want to own a stock in difficult times or if things are getting shaky? Why not just go for the safety of a Treasury bill, which essentially has a risk-free rate of return? The answer is that fear and greed can often drive the markets.

Defensive stocks accommodate greed by offering a higher dividend yield than can be made in low-interest-rate environments. They also alleviate fear because they're not as risky as regular stocks. It usually takes a significant catastrophe to derail their business model.

Defensive stocks tend to perform better than the broader market during recessions but they often perform below the market during an expansion phase due to their low beta or market-related risk. Defensive stocks typically have betas of less than 1.0.

Consider a stock with a beta of 0.5. The stock could be expected to lose only about 1% if the market drops 2% in a week. But a 2% price gain in the market for one week leads to an expected increase of just 1% for a defensive stock with a beta of 0.5.

Advantages of Defensive Stocks

Defensive stocks offer the substantial benefit of similar long-term gains but lower risk than other stocks. They have a higher Sharpe ratio as a group than the stock market has as a whole. That's a strong argument that defensive stocks are objectively better investments than other stocks.

Warren Buffett became one of the greatest investors of all time in part by focusing on defensive stocks. It's not necessary to take excessive risks to beat the market. Limiting losses with defensive stocks may be more effective.

Disadvantages of Defensive Stocks

On the downside, the low volatility of defensive stocks often leads to smaller gains during bull markets and a cycle of mistiming the market. Many investors abandon defensive stocks out of frustration with underperformance late in a bull market and this is when they need them the most.

Investors sometimes rush into defensive stocks after a downturn in the market even though it's too late. These failed attempts at market timing using defensive stocks can significantly lower the rate of return for investors.

Examples of Defensive Stocks

Defensive stocks are also known as noncyclical stocks because they're not highly correlated with the business cycle. There are a few types of defensive stocks.

Utilities

Water, gas, and electric utilities are examples of defensive stocks because people need them during all phases of the business cycle. Utility companies also get another benefit from a slower economic environment because interest rates tend to be lower.

Consumer Staples

Companies that produce or distribute consumer staples or goods that people tend to buy out of necessity are generally thought to be defensive. They include food, beverages, hygiene products, tobacco, and certain household items. Consumers will find a way to buy them regardless of economic conditions.

These companies generate steady cash flow and predictable earnings during both strong and weak economies. Their stocks tend to outperform nondefensive or consumer cyclical stocks that sell discretionary products during weak economies while underperforming them in strong economies.

Healthcare Stocks

Shares of major pharmaceutical companies and medical device makers have historically been considered defensive stocks. There will always be sick people in need of care. However, they aren't as defensive as they once were due to increased competition from new drugs and uncertainty surrounding regulations.

Apartment REITs

Apartment real estate investment trusts (REITs) are also deemed to be defensive because people always need shelter but steer clear of REITs that focus on ultra-high-end apartments when you're looking for defensive plays. You might also want to avoid office building REITs and industrial park REITs that could see defaults on leases rise when business slows.

The Bottom Line

Defensive stocks provide stable, consistent earnings and dividends. They're less susceptible to factors that affect the rest of the stock market. They’re much less risky but gains aren’t likely to be as substantial, particularly during bull markets. This isn’t to say that you should avoid them entirely but you might want to talk to an investment advisor about balancing your portfolio with other stocks.

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