Markets are anxious. Inflation remains over 4% in the US, recession risks are high, and the Fed is looking increasingly likely to continue its hiking campaign in 2023. As such, many investors are apprehensive about stocks. Here, we explore whether defensive equities are a good idea for your portfolio.
What Are Defensive Stocks?
Defensive stocks are stocks of companies that are considered relatively stable and less susceptible to economic downturns.
These companies typically operate in industries such as utilities, consumer staples (e.g., food, beverages, household products), healthcare, and telecommunications, which tend to have consistent demand regardless of the overall economic conditions.
The two most obvious indicators of defensive stocks are:
- Consistent returns.
- Stable earnings.
Why Are Defensive Stocks Important?
Defensive stocks are important because they can provide stability and protect your investment portfolio during periods of market volatility or recession. During times of turmoil, defensive stocks are typically a safer bet than growth-focused companies, as they tend to be more risk averse.
Currently, we think maintaining defensive positions is a good idea. This is because we think the market has priced in rate cuts for 2023 that will not happen, as inflation is turning out to be stickier than the Fed initially anticipated.
Examples Of Defensive Stocks
While we won’t mention specific defensive stocks, a few sectors are commonly associated with defensive stocks.
Utilities are considered defensive stocks primarily because they provide essential services that people rely on consistently, regardless of economic conditions. Electricity, gas, and water are necessities for households and businesses alike, ensuring a stable and reliable demand for utility companies’ services.
Moreover, utilities often operate as regulated monopolies, enjoying predictable cash flows and regulated pricing structures. These factors contribute to their relative stability during market downturns, making them attractive to investors seeking defensive investments that can weather economic uncertainties.
Companies in the consumer staples sector produce and sell essential products that people use regularly, regardless of the economic conditions. Examples include companies that manufacture and sell food, beverages, household products, personal care items, and basic healthcare products.
Healthcare companies, especially those involved in producing pharmaceuticals, medical devices, and healthcare services, are often considered defensive. Demand for healthcare remains relatively stable, as people require medical treatment regardless of the state of the economy.
Telecommunication companies, such as those providing wireless services, internet access, and communication infrastructure, are often seen as defensive stocks. These services are considered essential, and people continue to utilize them even during economic downturns.
Consumer Discretionary (Selective)
While the consumer discretionary sector is generally associated with more cyclical stocks, certain subsectors within it can have defensive characteristics. For example, companies providing essential services like home improvement products, discount retailers, or catering to budget-conscious consumers may exhibit defensive qualities.
Are REITs Defensive Stocks?
Real estate investments, particularly in the form of REITs, do not fall under the traditional definition of defensive stocks. While they can provide stable income and diversification benefits, real estate’s performance is influenced by factors like economic conditions and market dynamics, introducing volatility and risk. For example, they would suffer considerably during recessions accompanied by a housing market crash.
Benefits of Investing In Defensive Companies
Here are some of the major benefits of investing in defensive stocks:
- Defensive stocks are considered some of the safest investments in equities. These companies usually promise decent returns over the long term. Warren Buffet is especially known for preferring defensive stocks. In fact, Berkshire Hathaway in itself is considered a defensive stock by some.
- Defensive stocks have a lower beta, which is the volatility of a stock compared to the rest of the market. As such, they tend to be more stable stocks as opposed to cyclical companies.
- If the stock pays dividends, they tend to be constant and with a predictable growth rate.
- Even if the market is in a bull run, defensive stocks can offer much-needed diversification, even for growth-focused investors.
Drawbacks and Risks of Defensive Investments
Of course, no investment in stocks is going to be completely safe. Here are some things you need to watch out for when looking for defensive investments.
- Stable stocks might not lose a lot of their value during downturns, but they also tend to underperform cyclical sectors during bull runs.
- Defensive stocks also tend to become overvalued during recessions.
- In extreme market downturns or financial crises, even defensive stocks can experience declines.
5 Steps on How to Choose Defensive Stocks:
- Determine whether you need to hold defensive positions. For example, at Macro Hive we liked to maintain defensive positions given the May 2023 Fed meeting, as we expected rates to climb. That is exactly what happened!
- Decide which sectors you would like to invest in. We have already mentioned some of the sectors that are considered to be defensive above.
- Once you have picked the sector, start researching the stocks themselves. Perform due diligence like you would for any other company. On top of that, gauge the companies on the factors above that make a stock defensive.
- Once you have decided the company and the amount of stock you want to buy, purchase the stock through your broker.
- Remember that it is also possible to purchase defensive stock ETFs that allow you to diversify across multiple relatively safe stocks.
Are Defensive Stocks a Good Buy Right Now?
As of May 2023, we like defensive stocks due to the high likelihood of recession later in the year. Overall, though, we are underweight equities in our Asset Allocation.
We believe that the market has underestimated just how many rate hikes will be required to stabilize the economy. According to Dominique Dwor-Frecaut, the terminal FED funds rate will be near 8%. This means that equities could take further hits, making defensive stocks attractive.
Of course, this does not apply to all stocks. At Macro Hive, we like to stay long financials. These companies stand to benefit from the rate increases and there is a good chance that the market has undervalued the sector after the US bank failures.
Defensive stocks are ideal when it seems like there might be uncertainty in the stock market ahead. They typically exhibit stable earnings, consistent returns, and a low correlation to business cycles.
Considering the current state of the economy, defensive stocks might be a good idea. Those not looking to conduct their own research could invest in a defense stock ETF.
→ What Are The 5 Safest Stocks To Buy?
Stocks in the utilities, consumer staples, healthcare, and telecommunications sector are typically considered safe or defensive compared with cyclical stocks.
→ What Stocks Perform Best During Inflation?
Stocks that can scale prices as inflation rises tend to perform well. These may include businesses with strong pricing power, established brands, or those operating in industries with inelastic demand, such as healthcare or essential consumer goods.
→ Is Apple A Defensive Stock?
Apple Inc. is generally not considered a defensive stock in the traditional sense. The company operates in the technology sector, which tends to be more cyclical and susceptible to market fluctuations.