What makes the stock market an interesting place is the sheer diversity of stocks to invest in. There are some stocks that help you enhance the returns of your portfolio. This category of stocks does well in rising markets. Then, there is another category of stocks that protects your portfolio from any potential downside when the markets turn volatile. They are called defensive stocks. Let us understand in detail why defensive stocks are an integral part of many investors’ portfolios.
As the name suggests, defensive stocks are those that investors prefer to park their money in when the markets turn volatile as they tend to not fall as much as the broader markets. Many investors turn to defensive stocks when they sense there is going to be a large correction in the stock market. The objective of investing in defensive stocks is to limit the downside.
Why are they called ‘defensive’?
A key thing to understand about defensive stocks is that they must not be confused with stocks of the defence sector. Stocks of companies that produce goods and services that have a stable demand irrespective of the economic sentiment are said to be defensive. For example, a company manufacturing salt sees stable demand irrespective of the direction in which the economy is heading.
Defensive stocks are generally backed by well-established business models and a long operating history. Investors are aware that their business is stable and that they will keep generating profits over a long period of time. For example, companies manufacturing and marketing fast moving consumer goods such as biscuits, soaps, and shampoos do not get affected by a slowdown in the economy. The demand for their products is relatively income inelastic. Put simply, the demand for these goods does not change much with the change in the income of the consumer.
Similarly, pharmaceuticals and healthcare companies also enjoy a stable demand. Hospital bed occupancy does not change much with the changing state of the economy. Utilities such as power generation and distribution companies also enjoy relatively stable demand. Power consumption, especially household power consumption, which is a major component of overall power consumption, does not change much with a change in rate of growth in the economy.
Here are some characteristics of defensive stocks:
Stable demand
These stocks are backed by businesses that produce goods and services that do not go out of demand. They generally produce essential items such as food and medicines. These are non-cyclical businesses. In a cyclical business, demand for products fluctuates. For example, steel stocks do well when the economy is doing well. But when the economy goes into recession, these stocks are beaten down so much that they take years to bounce back meaningfully.
Low beta
Many defensive stocks are low-beta stocks. Beta is a measure of volatility of the share price. It tells us how much a stock moves in comparison to the broad market or an index. For example, if a stock moves 5% when the market has moved 10% then the stock is said to have a beta of 0.5.
Not linked to the economy
Stocks in the information technology sector in India are also seen as a defensive play. Since most of the companies in this sector earn their income overseas, they are not linked to the state of the domestic economy. When there is a slowdown seen in the Indian economy or when the stock market is volatile, investors turn to information technology stocks.
Given these facts, it is clear that defensive stocks help contain the downside of an equity portfolio. Most investors focus largely on investing in stocks that have high prospects of a strong upside. But it is equally important to protect the downside of your portfolio. This is because defensive stocks mitigate the impact of losses of your portfolio. Savvy investors use defensive stocks in a downturn but increase their exposure to cyclical stocks when the economy is in a boom phase.