Understanding Defensive Stocks Pros Cons Examples
Understanding Defensive Stocks: Pros & Cons, Examples
Defensive stocks provide consistent dividends and stable earnings regardless of the overall stock market. They have a constant demand for their products, making them more stable during the business cycle. Defensive stocks should not be confused with defense stocks, which are companies that manufacture weapons, ammunition, and fighter jets.
Key Takeaways:
– Defensive stocks offer consistent dividends and stable earnings.
– Well-established companies like Procter & Gamble, Johnson & Johnson, Philip Morris International, and Coca-Cola are considered defensive stocks.
– Defensive stocks provide long-term gains with lower risk.
– On the downside, the low volatility of defensive stocks can lead to smaller gains during bull markets and mistiming the market.
Investors turn to defensive stocks to protect their portfolios during a weakening economy or high volatility. Companies like Procter & Gamble, Johnson & Johnson, Philip Morris International, and Coca-Cola are examples of well-established defensive stocks. These companies have strong cash flows, stable operations, and the ability to weather economic downturns. They also pay dividends, which cushion a stock’s price during market declines.
Defensive stocks are less likely to face bankruptcy due to their relative strength during downturns.
In difficult times or when things are shaky, owning a stock can still be beneficial. Defensive stocks offer a higher dividend yield than low-interest-rate environments, making them attractive to investors driven by fear and greed. These stocks are less risky than regular stocks and require a significant catastrophe to derail their business model. Investment managers often migrate toward defensive stocks during challenging times.
Defensive stocks perform better than the broader market during recessions but tend to underperform during an expansion phase. This is because they have a low beta or market-related risk, typically less than 1. For example, a stock with a beta of 0.5 would only lose about 1% if the market drops 2%.
Advantages of Defensive Stocks:
– Defensive stocks provide long-term gains with lower risk.
– Defensive stocks have a higher Sharpe ratio than the overall stock market.
– Focusing on defensive stocks, Warren Buffett became one of the greatest investors.
Disadvantages of Defensive Stocks:
– Defensive stocks often lead to smaller gains during bull markets and mistiming the market.
– Many investors abandon defensive stocks due to frustration with underperformance late in a bull market.
– Attempting to time the market using defensive stocks can significantly lower the rate of return.
Examples of Defensive Stocks:
– Utilities: Water, gas, and electric utilities are defensive stocks because they are needed throughout the business cycle.
– Consumer Staples: Companies producing or distributing goods people buy out of necessity regardless of economic conditions are considered defensive.
– Healthcare Stocks: Major pharmaceutical companies and medical device makers have historically been defensive stocks, although increased competition and regulatory uncertainty have impacted their defensiveness.
– Apartment REITs: Apartment real estate investment trusts are defensive because people always need shelter. It’s best to avoid REITs focused on ultra-high-end apartments and office or industrial park REITs that may face increased defaults on leases during a business slowdown.
Overall, defensive stocks provide stable returns and lower risk compared to other stocks. However, they may underperform during bull markets and require careful timing to maximize returns.
