Pros and Cons of Investing in Defensive Stocks.

People across the globe invest with a goal of making their money grow and generating wealth. However, growth cannot be the ultimate goal, attributing to the fluctuating and unpredictable nature of stock markets. Finding the right stocks with steady long-term returns, irrespective of the state of the stock market, is a daunting task.

In response to this, a smart investment strategy is critical to reducing the overall risk of the portfolio. While certainly not guaranteed, defensive stocks tend to perform well against volatile markets and economic downturns. These stocks provide a safety net to your portfolio during high volatility or recession.

Now let's take a closer look at what defensive stocks are, which industries have defensive stocks and the pros and cons of investing in defensive stocks.

What Are Defensive Stocks?

As their name suggests, defensive stocks defend an investment portfolio against loss of value during an economic decline. Defensive stocks provide investors with consistent dividends and steady earnings regardless of the market trend (bullish or bearish). There is a constantly higher demand for defensive stock products, and conservative investors invest in defensive stocks to preserve capital against market volatility.

Which Industries Have Defensive Stocks?

Defensive stocks are characterized as non-cyclical as they are unaffected by market swings. Here's a list of industries of defensive stocks.

India's utility sector (water, gas, electricity) plays a vital role in social and economic development and has a market capitalization of over $1.58 trillion as of July, 2022.  Water, gas, and electricity are the necessities of life, and their demand is constant in all phases of the economy. For instance, NTPC, India's largest Power Utility, is a defensive player currently trading at ₹167.30. NTPC's PB ratio is 1.17, which is lower than the sector PB of 4.11, showing that the company's stocks are not overvalued. This stock offers good dividends and a dividend yield of approximately 5%. The cheap valuation of the company and a consistent track record of dividend payments for the last five years make it an attractive option for investors.

Interestingly, utility companies benefit during a recession or economic slowdown by securing borrowings at a lower interest rate.

Regardless of the economic conditions, companies that produce or distribute consumer goods like food, beverages, household items, tobacco, hygiene products, and others fall under defensive stocks. These companies generate steady cash flow and predictable earnings in all economic conditions. For instance, ITC Limited is a defensive stock that has survived the tale of Covid-19 with its FMCG business. The company has a good dividend track record and declared dividends consistently over the last many years. The current dividend yield is around 3.51% which is higher than the sector dividend yield of 1.44%. As per a recent report, 94% of analysts have suggested that investors can buy this stock.

However, these stocks outperform cyclical stocks during weak economic conditions and under-perform them in strong economic conditions.

The outbreak of novel coronavirus in 2020 has highlighted that medical aid is necessary for all. Pharmaceutical companies, insurance companies, hospitals, diagnostic entities, and medical device manufacturers are defensive stocks, as medical assistance is mandatory irrespective of the state of the economy.  For instance, Dr.Reddy's laboratories is a pharmaceutical company engaged in the business of providing medicines, an excellent defensive stock showing an increase in revenue and profitability consistently. This stock generates a better return on equity than bank FD.

However, the proliferation of new and branded drugs has increased competition, and these stocks are now not as defensive as considered earlier.

Pros of Defensive Stocks:

Defensive stocks are more or less immune to market changes and provide stable returns irrespective of all the ups and downs of the market. The stability of returns in the form of dividends makes it easier to predict investment growth over time. These stocks help meet specific financial goals like retirement. For instance, essential FMCG products will never go out of fashion and will always witness a consistent demand. The core idea is to design a portfolio with a significant investment in defensive stocks that can act as a defense/hedge against unpredictable swings in the stock markets.

Defensive stocks are low-risk, long-term investment options. With the perennial demand for defensive goods and services, it is improbable to witness a dip in demand for defensive stocks during a recession or an economic downturn. This characteristic makes it a viable option for conservative investors to park their idle funds for the long term and protect their wealth against significant losses.

Defensive stocks safeguard against market volatility. Investors can streamline returns and reduce the portfolio's overall risk by striking a perfect balance between defensive stocks (low beta stocks) and non-defensive stocks (high beta stocks). Defensive stocks will perform well in recessionary situations due to inelastic demand for goods and services.

Cons of Defensive Stocks:

The flip side of defensive stocks is that low volatility leads to smaller gains in periods of high economic growth. When other stocks are soaring, these stocks tend to perform below the market. Under-performance during bull markets leads to lower returns, which might influence investors to abandon their investment in defensive stocks.

Rising interest rates can have significant implications on defensive stocks. When interest rates rise, alternative securities like corporate bonds, bank deposits, treasury bills, and others become more lucrative to invest in than defensive stocks. For instance, if a defensive stock yields 5% and the interest rate rises to 7-8%, investors start selling defensive stocks. The prices of defensive stocks will start falling with the increased selling of stocks. Rising interest rates impact a company's earnings and reduce profit after interest and tax, thereby reducing dividends.

Defensive stocks might get overvalued during an economic slowdown. During a recession, many buyers will chase a stock, leading to an exorbitant increase in its share price. This leads to inflated prices and makes the stock look expensive.

Conclusion:

Every investor is apprehensive of the high volatility and risk associated with stock markets. In response, defensive stocks offer an appropriate investment avenue to weather the recession and tempered economic environment. A steady and consistent return on defensive stocks requires an investor to include a certain percentage of investment towards defensive stocks to sail through the twists and turns of the stock market.

As an investor, it is recommended to choose the right investment options with calculated risks. A thorough understanding of defensive stocks and market trends can help you fetch better returns.

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