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Buying Defensive Stocks

Moneyzine Editor
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Moneyzine Editor
4 mins
January 9th, 2024
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Buying Defensive Stocks

During economic recessions, or market downturns, investors typically add defensive stocks to their portfolios. These stocks can be expected to perform relatively well during all phases of a business cycle, even during difficult economic conditions. In this article, we're going to help define what is meant by a defensive stock. As part of that definition, we're going to explain how to identify these companies. We're also going to talk about the pros and cons of investing in these stocks, including the best time to buy them.

Defensive Stock Theory

A defensive stock is usually associated with a company that belongs to an industry or market sector that is unaffected by business cycles. That is to say, consumer demand for their products or services remains strong no matter how well, or how badly, the economy is performing. Defensive stocks are the opposite of cyclical stocks, whereby the financial health of cyclical companies move in-sync with the health of the economy. That's why these stocks are also referred to as noncyclical stocks.

Identifying Defensive Stocks

The easiest way to identify a defensive stock is by thinking back to the very basic needs we all have as human beings: food, health or well-being, clothing, and shelter. If a company provides a service, or manufactures a product, that fulfills these needs, then it's very likely consumer demand for their products or services will remain strong even when economic times are dire. Examples of defensive stocks include companies belonging to the following market sectors:

  • Utilities: including electricity, natural gas, propane, heating fuel oil, and water. At one time, this list would have included telephone and cable television companies, but competition has eliminated the "captive" customers these companies once enjoyed when they owned franchise territories.

  • Food and Beverages: including producers of food products, beverages (including those containing alcohol), and sometimes fast food restaurants that compete for customers based on the price of their offerings.

  • Healthcare: includes companies that manufacture pharmaceuticals and medical devices, testing laboratories, and insurance companies.

  • Non-Durable Goods: includes household goods that are quickly consumed such as soap, detergent, deodorant, and toothpaste. These are essential household items that most consumers will purchase even if money is tight.

Stock Beta and Noncyclical Stocks

The concept of stock beta is fairly easy to understand. It's a measure of individual stock risk relative to the overall risk of the stock market itself. It's also sometimes referred to as financial elasticity. By their very nature, noncyclical stocks have lower than average systematic risk. Two generalizations we can make about the beta calculation include:

  • If the stock's price experiences movements that are greater (more volatile) than the stock market, then the beta value will be greater than one.

  • If a stock's price movements or swings are less than those of the overall stock market, then we should expect the stock's beta value to be less than one.

Defensive stocks: Also referred to as noncyclical stocks, the financial health of these companies do NOT move in sync with the economy
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The above relationships tell us that a defensive stock will tend to have a beta value that is less than 1.0. Since we also know that less volatility means lower risk, then we'd expect defensive stocks to provide investors with an overall lower return on investment.

Pros and Cons of Investing in Defensive Stocks

The biggest advantage an investor gains through the purchase of defensive stocks is a conservative portfolio, which should provide above-average returns during a recession. The profitability of these stocks will hold up during these hard economic times because the demand for the products or services of these companies is relatively inelastic. That is to say, even when money is tight, consumers' demand will remain relatively unchanged. The same attributes that allow these companies to provide above-average returns during a recession, will also result in below-average returns when an economy rebounds. This is the biggest disadvantage of investing in a noncyclical stock. They neither fall as fast as other stocks during a bear market, nor rise as fast as other stocks during a bull market.

When to Buy Defensive Stocks

The best time to buy noncyclical stocks is just before the economy enters a downturn. That's the reason they're referred to as defensive stocks. They can provide investors with a safety net during turbulent times. Once a market is firmly entrenched in a bear market, it's often too late to invest in a defensive stock. Finally, the worst time to invest in this class of stocks is at the start of a bull market. With a beta of less than one, these stocks can be expected to return less-than-average profits when the rest of the stock market is climbing higher.

Additional Resources

  • Finding the Best Stocks to Buy
    As investors, it's important to know how to go about finding the best stocks to buy. Before it's possible to successfully choose these stocks; however, it's essential to understand some of the fundamentals of evaluating securities.
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    Moneyzine Editor
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  • Dividend Paying Stocks
    When interest rates are low, retirees and other investors turn to dividend paying stocks to provide them with a reliable source of income. In fact, investing in companies paying high dividend yields is often viewed as the "sensible" or "rainy day" approach to creating an investment portfolio.
    Moneyzine Editor
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    January 16th, 2024
  • Value vs Growth Stocks
    Investors are constantly faced with the decision between risk and return. The same logic applies to growth versus value stocks. Rationale investors will agree that picking a quality stock is important, but not everyone agrees that value is more important than growth.
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    Hristina Nikolovska
    January 19th, 2024
  • Buying Preferred Stock
    When investors talk about buying stocks, they're typically referring to shares of common stock. But preferred stock offers the investor the advantages of both common stock and bonds, and is oftentimes a compromise worth pursuing. In terms of financing, preferred stock usually occupies a relatively small percentage of the overall mix of a company's capitalization; typically accounting for less than 10% of a company's overall source of funds. That's because from a tax standpoint, preferred stock is treated as equity, but the requirements for dividends are more like bond payments.
    Moneyzine Editor
    Moneyzine Editor
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  • Buying Cyclical Stocks
    There is no doubt the stock market presents individuals with a variety of investment opportunities every trading day. One of the opportunities investor should be familiar with is cyclical stocks. As consumers, we are at the mercy of large economic swings or cycles. As investors, we realize these same economic cycles provide us with a chance to grow our investment returns or protect ourselves; if we know what signals to look for.
    Moneyzine Editor
    Moneyzine Editor
    January 9th, 2024
  • Blue Chip Stocks
    When investors talk about quality stocks, they'll often use the phrase "blue chip." Unfortunately, even seasoned market analysts can't agree on a definition of this term. But they do agree that blue chip stocks have some very desirable attributes.
    Moneyzine Editor
    Moneyzine Editor
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  • Diversifying Your Portfolio
    With stock ownership, it's certainly possible to have too much of a good thing. Diversity of stock holdings is important, just ask any former employee of Enron. When that company filed for bankruptcy, thousands of employees lost nearly all their savings. In this article, we're going to explain why experts feel investors should avoid putting more than 10% of their portfolio's assets into one company's stock. We'll also explain how to go about diversifying a portfolio, as well as providing an example to demonstrate the positive impact holding an assortment of stocks can have on your return on investment.
    Moneyzine Editor
    Moneyzine Editor
    January 16th, 2024

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