Here are 3 ways to identify defensive stocks to protect your portfolio

A defensive stock is an investment that seeks to protect investors from market downturns. Defensive stocks generally have a low beta and are relatively stable in terms of their price. These companies can provide a cushion against market losses, since they tend to be less affected by swings in the markets than other stocks.

But is this always the case? And how can you identify a defensive stock?

 

Sectors to look for defensive stocks in

Defensive stocks tend to be investments in sectors that are considered to be more stable and reliable over time, i.e. less likely to fluctuate with broader economic conditions. These include utilities, consumer staples, healthcare and certain industrial sectors.

These sectors generally have relatively consistent demand for their products and services. Larger companies also offer dividend payments that can provide investors with a cushion against market downturns.

 

Things we need every day

In the Utilities sector, companies generally provide essential services to households and businesses such as electricity, gas or water. Consumer staples refers to companies that manufacture everyday items like food, beverages and cosmetics. Healthcare covers pharmaceuticals, medical equipment manufacturers and health insurance providers. Lastly, the Industrial sectors include manufacturing of basic materials, such as chemicals, as well as producers of durable goods such as cars and appliances.

 

Lower returns, but more stable

These defensive investments typically offer lower returns than other more volatile stocks in the market, but can help to protect investors from large losses during bear markets or periods of economic uncertainty.

Additionally these stocks may not be affected by changes in sentiment due to macroeconomic news or political events, reducing the risk associated with investing in them. As such, they are considered a good choice for investors who are looking for long term stability rather than high yields.

Other ways to identify defensive stocks

Another way to identify defensive stocks is to look for individual companies that have a track record of performance during economic downturns. One example is the world’s largest fast food company McDonalds (NYSE:MCD). During 2008, the year the GFC struck, its shares actually rose more than they did in 2006 and 2007.

During 2022, a year when interest rates rose by the fastest pace in decades and inflation reached 4-decade highs, McDonalds outperformed the S&P 500 by 18%.

Investors could also look to a company’s beta. Companies with a beta of less than one are less volatile than the market and tend to be defensive stocks. On the other hand, companies with a beta that is greater than one are more volatile than the market.

 

Downsides of defensive stocks

While defensive stocks can protect investors from losses during economic downturns, their returns tend to be lower than those of more volatile investments, because defensive companies usually have lower growth rates than other types of investments due to their conservative approach to management.  

Additionally, because these companies don’t rely on major capital projects or new product launches for growth, their stock prices can remain stagnant for longer periods of time without any major developments that would lead to large gains or losses.

 

Even dependable stocks can have bad years

The example we used above, McDonalds, also depicts that defensive stocks may not be completely immune to downturns. Even though it outperformed the S&P500 in CY22, shares still fell by 2%. And during the 2010s, it had some dour periods, including between 2012-2014 under the tenure of Don Thompson.

As the economy recovered from the GFC, competition from other restaurant chains (including some that were more health conscious) heated up and the company did little to address it until there was a change of leadership.

 

Examples of defensive stocks on the ASX

It is difficult to succinctly define a company as a defensive stock. However, potential candidates could include supermarket giants Coles (ASX:COL) and Woolworths (ASX:WOW), given that consumers will always need groceries.

One might also argue that toll road operators, such as Transurban (ASX:TCL) are immune to economic downturns and therefore are defensive stocks. This may be accepted during downturns that are purely economic. But the pandemic, and the consequential drop in road users, has depicted that they are not completely immune to unusual events.

Vaccine and blood plasma product maker CSL (ASX:CSL) is similarly renowned as a defensive stock, given its track record of long-term growth. But similar to Transurban, CSL likewise saw a downturn in activity during the pandemic because non-COVID activity in hospitals was essentially non-existent for several months.

 

Defensive stocks need to be part of a balanced portfolio

Investors that only hold defensive stocks may miss out on the worst of losses from bear markets, but they will also miss out on the best returns during bull markets. As a consequence, we think that defensive stocks should only be part of a balanced portfolio that includes some companies with the potential for higher returns.

 

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