Defensive Stock

What is a defensive stock?

A defensive stock is a type of stock that generates a constant dividend and stable earnings independently of the state of the stockmarket performance. Defensive stocks are typical of firms that produce or distribute consumer staples, which are goods people tend to buy out of necessity regardless of economic conditions. These include energy, gas, food, beverages, hygiene products, tobacco, medicines and certain household items.

Because of the constant demand regardless of the general economic situation, defensive stocks tend to remain stable during the various phases of the business cycle. These defensive stocks should not be confused with a “defence stock”, which refers to weapons and ammunition companies.

When the economy enters in a phase of recession, defensive stocks tend to perform better than the market due to their stable nature. However, in an expansionary economy, they tend to perform below the market. This is attributed to their low beta as defensive stocks typically have betas of less than one.

Example of a defensive stock

Consider a stock with a beta of 0.4. If the market is expected to drop 10%, and the existing risk-free rate is 5%, a defensive stock will only drop 6% (0.4 x (-10%-5%)). On the other hand, if the market is expected to rise up 10%, with a risk-free rate of 5%, a defensive stock will only increase 2% (0.4 x (10%-5%)).

The utilities are the classic example of defensive stocks. During all phases of the business cycle, people will need gas and electricity. Investors tend to invest in defensive stocks if a market downturn is expected.

However, if the market is expected to prosper, active investors will often choose stocks with higher betas in an attempt to maximise return. Defensive stocks are also known as “non-cyclical stocks” because they are not highly correlated with the business cycle.

Category: Financial Glossary

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