Defensive stocks are based on underlying assets which tend to be less prone to economic and credit cycles than others. Because of this, they’re generally invested in when traders see an economic slowdown approaching and want to hedge their portfolios.
Different securities can be desirable to investors for different reasons. Some are highly volatile but have the potential for quick, large returns. Other securities are less volatile, perhaps even less glamorous, but tend to be more reliable. Such securities are known as defensive stocks.
Examples of Defensive Stocks
Defensive stocks appear across different sectors. Some examples are:
Perhaps the most common defensive stocks are based on utilities. 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.
Non-Cyclical Consumer Goods
Consumer goods can be broken down into different sectors, including cyclical and non-cyclical.
Non-cyclical consumer goods are seen as defensive because, like utilities, people will consume them regardless of how markets are performing. Manufacturers of non-durable hygiene items such as soap and toothpaste are popular defensive stocks – L’Oreal on the French CAC-40 is one such example. Basic foodstuffs such as bread and milk can also be defensive.
Some ‘discretionary’ items have also historically been regarded as defensive stocks. These are non-essential items which remain strong performers during economic downturns. One such stock is Coca Cola.
It isn’t something people need for survival, but Coca Cola is so embedded in the business and cultural landscape that it’s strength has previously been assured (however, it’s worth noting that in late 2018, Swiss banking giant UBS downgraded their view of Coca Cola from ‘buy’ to ‘neutral’ – despite their shares over-performing on the S&P 500).
Tobacco is another one-time staple of defensive portfolios that has become less reliable over the past decade, thanks to increased sales restrictions and the rise of e-cigarettes and vaping. It should always be remembered that defensive stocks aren’t wholly immune to market conditions – especially stocks which are non-essential but have a strong reputation.
Healthcare is another sector that will always be in demand. Healthcare stocks can be divided into four categories:
: These are companies, also known as ‘big pharmas’, which produce over-the-counter drugs and medicines. They also invest heavily in the research and development of healthcare products. Examples of such stocks include Johnson & Johnson, GlaxoSmithKline and Pfizer.
: Biotechnology companies provide the same products as pharmaceuticals. The difference is that biotech companies derive their medicines from living organisms, whereas pharmaceuticals develop theirs from chemicals. Biotech companies include the likes of Immunocore and Horizon in the UK, and Amgen and Gilead Sciences in the US.
: These are the companies which provide and run services such as hospitals, care-homes, clinics etc. Although some parts of the world (such as the UK, France and Germany) have a universal healthcare system, there are still private healthcare companies (such as Bupa in the UK) which run alongside them.
: Companies which manufacture equipment for healthcare services and pharmaceutical services – from surgical equipment to staff uniforms – can be seen as strong defensive stocks. Some of the biggest medical device companies include Medtronic, Philips Healthcare and DePuy Synthes (a medical device subsidiary of Johnson & Johnson).
Defensive assets are different to defensive stocks, but are worth mentioning as they can perform a similar function in portfolio protection for the same reason: they are generally less susceptible to market conditions than growth stocks. Defensive assets can include precious metals such as gold and silver, commodities such as rice and tea, and government bonds.
Defensive Stock Beta
Defensive stocks have a beta coefficient of less than 1.0, meaning they are less volatile than the index of which they are a component. This means that whilst their performance is below that of the market during expansionary periods, they tend to perform above the market in periods of contraction.
For more information on how beta and how it’s calculated, you can read our article here.
Traders can find indices comprised of defensive stocks. These are part of a wider family of ‘stability indexes’.
New York-based MCSI provide a World Defensive Sectors Capped Index and USA Defensive Sectors Index. In the UK, the FTSE-maintained Russell 2000 Defensive Index represents mainly US-based defensive stocks. To qualify for inclusion, each stock must display a high stability probability as defined by the methodology of each index.
To explain what makes a strong, investable business; leading investor Warren Buffett developed the ‘moat’ metaphor.
If you think of fortresses, those that will be best-defended are those with the deepest, widest moats around them. The same principle applies in business: if a company has a strong advantage over its rivals, it will be able to protect its market share and profitability for longer.
The moat metaphor fits defensive stocks perfectly. The necessity of utilities, medicine and hygiene products gives those stocks a moat to protect them from systematic risk. One might also argue that the worldwide ubiquity and instantly recognisable branding of stocks such as McDonald’s or Coca Cola provide a moat against their competitors.
Small Cap Defensive Stocks
The companies and brands mentioned throughout this piece have all been large cap stocks. It may appear to be a given that large cap stocks are naturally defensive because their size and established reputation provide them with a moat.
There is however an argument that small cap stocks can be defensive. This may seem like a contradiction in terms but it is a strategy that can work given certain market conditions. For example, imagine two companies based in the US: Company A is a large cap stock with a worldwide presence, Company B a small cap domestic manufacturer of hygiene products.
If the US market is performing well as world markets are slowing down, Company A will still be exposed to underperforming markets. Company B on the other hand, is well positioned because of its defensive nature and lack of exposure to wider uncertainty.
However, this theory is only one that should be tested by experienced investors intimate with on-going worldwide and domestic economic conditions.