What are Defensive Stocks?

A defensive stock refers to a stock that gives consistent returns to its shareholders in the form of dividends, regardless of the stock market’s overall performance. These stocks can generate stable earnings in good and bad economic cycles. It is because the nature of the underlying business is such that people are constantly consuming their products. FMCG, utilities, retail, and personal care stocks fall under defensive stocks.  

The defensive share also traditionally comes from several sectors that have one thing in common: they produce necessities or consumable products essential for daily usage.  For instance, if a company manufactures and sells a product like toothpaste or eatables, people will consume such products no matter what the situation is. They will have to spend on food to fill their stomachs. You must have understood the defensive stocks definition; let’s discuss reasons to invest in these stocks, their pros and cons and more.

Key Highlights

• Defensive stocks are the stocks that give stable returns to the investors in the form of dividends, irrespective of the stock market’s performance.

• Some examples of defensive stocks are utilities, healthcare, or personal care.

• These stocks protect investors during a recession in the economy or a global crisis.

• They also act as a hedge to cyclical and growth stocks.

Role of Defensive Stock in a Portfolio

The following are the roles of these stocks in a portfolio:

• One of the primary roles of a defensive stock is to preserve one’s capital. 
• Defensive stocks provide relief to investors during periods of high uncertainty and volatility in the stock market. They save the investor’s portfolio from crashing during a recession in the economy or a global crisis. 
• Defensive stocks also act as a hedge to cyclical and growth stocks. They help offset the losses a cyclical or growth stock may incur during a bear market. 
• Good defensive stocks can deliver steady returns to their shareholders. They are very capable of outperforming the more significant market as well. 

Reasons to Invest in this Type of Security

There are several reasons to invest in such securities. Some of the key reasons are:

• An Ideal Investment for Beginners

For beginners, this type of stock is a good option for starting with their investments. It allows investors to get a return and avoid running their capital on highly volatile stocks. If you want your investment to be low in terms of risk factors and don’t have enough knowledge about the stock market, then you should try these stocks.

• Chance of a Steady Income Stream

As you are aware, the dividend fund in the stock market. A dividend means a small profit share that a company provides to its shareholders, despite the market being bullish or bearish. These stocks will give you a decent dividend and provide a steady income. If the market conditions are volatile, you still get a dividend at the determined time of the company. But before you buy any stock, you must identify the defensive stock and the company product or service, how it’s one of the primary necessities, and why people buy it regularly. 

• Potential for Growth

One of the oldest qualities of defensive stocks is their undervalue in P/E and P/BV. In most of the big corporations in the Indian stock market, you can observe the valuation of these companies is high. These companies also have a potential where growth is limited. But you can be assured that this company’s downside risk is pretty stable. And when there is a period of bearish or market fall, you can buy these stocks and wait until they bounce back to their stable or more than the initial value of the stock.

Industries Covered by Defensive Stocks

Stocks belonging to the following industries fall under the category of defensive stocks.

1. Fast Moving Consumer Goods

The FMCG or Fast Moving Consumer Goods industry is the most popular industry to have defensive stocks. These industries sell foods and beverages like instant noodles and pasta, milk, colas, baby formula, and chocolates. The industry includes personal care products like soaps, shampoos, and toothpaste. Tobacco and alcohol also come under the label of FMCG. 

2. Retail

The consumer retail industry also acts as a proxy to the FMCG industry as most products they sell fall under the FMCG category. Hence consumer retail stocks may also portray defensive characteristics.

3. Utilities

Utilities like gas and electricity stocks are essential requirements for a sustainable livelihood. So power and gas stocks are also not affected during market corrections or economic downturns, as people continue to consume and pay for their gas and electricity supply. 

Pros and Cons of Defensive Stocks

The following are the pros of investing in these stocks:

• Stable earnings: Since these stocks provide consistent dividends and generate stable earnings, investors tend to hold onto these stocks. 

• Less volatile: Sometimes, the underlying company may be sitting on too much surplus cash to give its shareholders multiple dividends in a single financial year. This is why defensive stocks are less volatile than cyclical and growth stocks. As a result, they have a lower beta value than the overall market. 

• Minor market corrections: During market corrections, the stock price of defensive stocks shows only a minor correction. At times, they may even remain unaffected. 

• Potential to manage market downturns: During economic crises or downturns, growth stocks and cyclical stocks may plummet. But, at the same time, defensive stocks may still manage to hold their ground relative to other stocks. 

• Less risky investment option: When compared to cyclical and growth stocks, they are less risky investments. These stocks tend to have a Sharp Ratio, which is higher than indices like the Nifty 50 or the Sensex. Investors don’t need to take a high risk to beat the market. Good defensive stocks are very capable of beating the market. 

• Potential to combat inflation: The gradual increase in their earnings can reflect the stock price. Defensive stocks of established companies can even combat high inflation to an extent. Their brand value gives them high pricing power. Due to the nature of their business, people will continue to purchase their products despite the price increase. 

However, investing in defensive stocks has its fair share of downsides. Or else, every investor would pump their money into defensive stocks. The following are the downsides of these stocks:

• Less Potential for Significant Growth: Due to their lower volatility or low beta values, the stock price of these stocks may underperform during a bull market. The price may never plummet, but at the same time, it will even shoot up at a fast pace. A significant reason a defensive stock’s stock price barely rallies is that the underlying company is unlikely to show high earnings growth. 

• Consumer behaviour during economic boom: During an economic boom, people do not buy more of the company’s products. Their purchases will remain more or less the same. This is because the company’s balance sheet will exhibit similar earnings or a small earnings growth. At the same time, a cyclical company will exhibit high earnings growth. People will not buy extra soaps or toothpaste because the employment rates are high. Instead, people will buy cars and other premium goods. 

Conclusion

Defensive stocks provide consistent returns to shareholders in good and bad economic cycles. However, one should note that defensive stocks are still susceptible to some volatility and fluctuations. At times, the stock price may fail to increase by a significant number and may enter an extended consolidation phase. However, defensive stocks will continue to provide dividends to their shareholders as long as the earnings are stable. 

One must evaluate the risk and invest accordingly. Just because a company belongs to the FMCG or utility industry, one should not consider it a good investment option for a defensive stock. The business has to generate consistent profits to fall under defensive stocks regardless of the industry.  It is necessary to determine whether the stock is an excellent defensive stock by conducting a thorough fundamental analysis. If the management is poor, a defensive stock can also crash and may not recover. On the other hand, as long as the management of the underlying companies is competent, these companies will be cash-rich.

FAQs on Defensive Stocks