What do we understand by defensive stocks? Obviously, as the name suggests, these are the stocks that can be relied upon in the midst of volatile markets. These are the stocks that do not lose as much value as the typical high beta stocks when the market is correcting. So, what are the characteristics of defensive stocks and what are the benefits of defensive stocks in your portfolio. Is it possible to create of list of defensive stocks and what are the ideal defensive stocks examples? Let us look at some of the characteristics of defensive stocks and examples of such stocks from the Indian context..
1. Sectors that do not go out of fashion
When you talk of the traditional sectors that do not go out of fashion these include food, FMCG products etc. The form of consumption of food and detergents changes but the essential consumption hardly changes. In fact, these products only see increased demand as the income levels in the economy increase. Due to their stable demand structure, they tend to be less volatile and also manage to protect price and returns during tough times. In the Indian context stocks like Hindustan Unilever, ITC, Marico, Britannia, Havells are all classic examples. Of course, they may not give the kind of return that your typical high beta stocks would give but that is not the purpose anyways. The core idea is to focus on stocks that can protect your portfolio value in bad times.
2. Sectors that have perennial demand
This can be an extension of the previous argument but you have a variety of beneficiaries of this trend. Apart from food and FMCG, stocks in the pharmaceuticals and cement also fall under this category. For example, the demand for cement can be postponed but it cannot be done away with. That is why cement stocks have tended to hold value even in the toughest of markets. One can argue that Indian pharma has been going through a harrowing time in the last 3 years but that is for a different set of reasons altogether. It is a case of valuations adjusting to more rational growth expectations. But the demand for these products has hardly seen any tapering.
3. Attractive dividend yields
One good example of defensive stocks can be stocks with high dividend yield. Typically, stocks with dividend yields above 6-7% are great examples of defensive stocks. The attractive dividend yield makes them very attractive at lower levels due to the annuity income that they generate. In the Indian context, stocks like NTPC, Coal India, NMDC, REC, Chennai Petroleum, IOCL and BPCL fall into this category. They come from a wide range of sectors but the underlying theme is their attractive dividend yield. In many instances, the dividend yield is actually better than the bond yield itself.
4. Large companies with stable business models
We have seen this in the case of companies that have matured over a period of time and repeat business comes without much effort. Companies like TCS, Infosys, Reliance, Maruti etc fall in this category. Even when these companies correct in the stock market, the investors have a comfort level that such stocks will eventually bounce back. And over the years these stocks have rarely disappointed their investors. Such stocks can be good places to park your money in tough market conditions. They may not give you the kind of returns that many midcaps can give you but like typical defensive stocks they protect the downside risk beautifully.
5. Conservatively valued in P/E and P/BV terms
One of the classic conditions of defensive stocks is that they are stocks which still are relatively undervalued in terms of P/E and P/BV. If you take the example of some of the companies like Reliance, IOCL, BPCL, NTPC you will find that most of them are available at fairly compelling valuations. Of course, in most cases the growth potential is limited or the size works against them. But, you can be rest assured that such stocks will hold their downside risk pretty well. Also, when there is a correction they make a case for buying and you can be assured of a bounce in these stocks eventually. Low P/E and Low P/BV acts as an added advantage since valuations turn in their favour quite rapidly.
6. The business is not exactly cyclical
Let us take an analogy. Commodity businesses like steel, aluminium and zinc can be fairly cyclical as the price of metals is largely based on the international prices on the LME. In such cases, the potential for price damage is quite huge when the cycle turns against them. Secondly, when these stocks correct, it takes a very long time for them to recover the price damage since commodity cycles tend to last for longer periods of time. That is why most metal and commodity stocks are rarely defensive bets. Even if they are offering attractive P/E valuations they do not become basket defensive cases. The defensiveness comes more in cases of stocks where there is some moat to set them apart.
7. Stocks with low beta as defensive bets
You will typically find stocks with low betas to be defensive in nature. Take the Indian Nifty. Stocks like Cipla, ACC, Bajaj Auto, Hindustan Unilever, IOCL and Infosys are all example of stocks with Betas that are sharply lower than 1. Such stocks may not really flatter the street in bull markets but tend to hold value better when the markets are down or too volatile. On the other stocks like Bosch, Eicher Motors, ICICI Bank, Adani SEZ all tend to have fairly high betas and they cannot be good defensive bets. They are more to be played in aggressive markets.
Defensive stocks are a good place to protect value in bad market conditions. That is what defensives are all about!