Defensive shares, also known as defensive stocks or non-cyclical stocks, are shares issued by companies whose profits are less susceptible to changes in the country’s overall economic performance.
Defensive shares are the opposite of cyclical shares, which go up and down according to how well or badly the economy is doing.
Utility companies (gas, electricity and water) are less affected by a nation’s economic cycle than, for example, car makers or manufacturers of expensive watches, which suffer during recessions and thrive when there is an economic boom. Everybody needs water, butane gas and electricity all the time.
Defensive shares generally perform better than cyclical shares during recessions, while cyclical shares do better when the economy is expanding.
Defensive shares are more stable than cyclical shares. During a recession they generally perform better than the market, but below the market when the economy is expanding.
When investors believe the economy is about to slow down or enter a recession, they will increase the proportion of defensive stocks in their portfolio mix. Conversely, when they foresee a rise in economic activity, they will slant towards cyclical stocks.
Examples of defensive shares
Healthcare: such as companies that make medications and medical devices, insurance firms and testing laboratories.
Non-Durable Goods: goods bought by households that are consumed quickly, such as detergent, toothpaste, and soap. Consumers will buy these items regardless of how well/badly the national economy is doing.
Utilities: including suppliers of water, heating fuel oil, propane, natural gas, and electricity. This list used to include cable TV and telephone companies, however, competition has done away with the ‘captive’ customers businesses used to enjoy.
Food and Drink: such as producers of foods, beverages, and often fast-food restaurants (they offer cheap meals for people on tight budgets). Even sales of beverages containing alcohol are less vulnerable to the economic cycle.
Tobacco: – one would expect cigarette makers to see sales fall during a recession. However, nicotine addicts see cigarettes as essential items and are ‘loyal customers’, even when their financial situation deteriorates.
Advantages and disadvantages of investing in defensive stocks
Purchasing defensive stocks provides the investor with a conservative portfolio, which during a recession will provide above-average returns.
Defensive stocks will hold their own during recessions because demand for the products and services of these businesses is fairly steady. Even when the proportion of people on tight budgets increases, demand will remain relatively unaffected.
During an economic rebound, however, these companies will perform less impressively than cyclical businesses.
Most equity income funds have a higher proportion of defensive stocks, while growth funds tend to tilt towards cyclical shares.
An investment portfolio should consist of the two types of shares. They both have their potential merits. Their relative balance depends mainly on your market view, your risk tolerance, and requirements for dividends.
Video – What is a defensive stock?