This is a statement we often use in our regular usage. If markets are volatile get into defensive stocks. If markets are difficult to understand, then get into defensive stocks. If there are cyclical risks to the market, then get into defensive stocks. But, what exactly do we understand by the concept of defensive stocks? Intuitively, stocks like Hindustan Unilever, TCS and HDFC Bank appear to be defensive stocks. They don’t get impacted or too volatile by cycles in the market. While that argument is broadly correct, we need to look at some specific characteristics that actually define such defensive stocks.
At a very fundamental level, defensive stocks are the stocks that can be relied upon in volatile markets. They do not lose as much value which is common among high Beta stocks at a time when the markets are correcting sharply. Let us look at some of the unique features of defensive stocks that distinguish them as a category.
1. They are in boring businesses but never go out of fashion
Sectors that don’t go out of fashion include food, FMCG products, stable banks, solid IT companies etc. When it comes to food, banking services they may change in specific form but the service as a whole rarely goes out of fashion. These products see increased demand as the income levels in the economy increase. Such stocks tend to be less volatile and also manage to protect price and returns during tough times due to their stable nature. Stocks like Hindustan Unilever, Marico, Britannia, Havells, HDFC Bank, TCS are all classic examples of defensive stocks in the Indian context. The idea of defensive stocks is not to get fancy returns or multi-bagger wealth creation. The idea is to be able to maintain and protect value in touch economic and political conditions.
2. Demand patterns for such stocks do not have an element of cyclicality
If a stock goes through typical seasonal cycles or moves in tandem with global commodity cycles, then such stocks cannot become defensive stocks. Apart from food and FMCG, stocks in the pharmaceuticals and cement also fall under this category. Remember, the demand for cement can be postponed but cannot be done away with. Similarly, low cost housing can also be a defensive bet once the industry takes off in a full-fledged manner. Indian pharma continues to be defensive and the current problems are more a shift in the underlying nature of the industry. Demand for pharma products hardly tapers.
3. In bad times, high dividend yield stocks can also be defensive
Typically, stocks with dividend yields above 6-7% are classic examples of defensive stocks. The attractive dividend yield makes them attractive at lower levels due to the annuity income that they generate and thus this dividend yield acts as a price support for the stock. Stocks like Coal India, REC, PFC, Chennai Petroleum and IOCL fall in this category. If the dividend yield is higher than the bond yields, that by itself acts as a base for the stock.
4. Matured and stable business models can also be defensive bets
When markets are cracking, never try to predict the market. That does not make sense. You do not know at what level the market will bottom out and you never will. Focus on managing your risk. Also ensure that your long term goals are not impacted in any way as equities will eventually outperform other asset classes. For a 20 year goal, such corrections do not matter. If you are doing an equity fund SIP, use your discretion and increase the size of your SIP when markets are down so that your average cost comes down.
5. Stocks with conservative valuations can also be defensive stocks
One example of defensive stocks can refer to stocks that are relatively undervalued in terms of P/E and P/BV. For example, companies like Reliance, IOCL, BPCL, are still available at fairly compelling valuations. Of course, in most cases the size works against them. At least, you can be rest assured that such stocks will protect your downside risk. This principle must be very scrupulously applied only to stocks that have pedigree and a sound business mode and not to every company that quotes at low P/E or P/BV.
6. Low beta stocks can also be a kind of defensive bet for investors
Stocks with low betas naturally tend to be defensive in nature. Within the Nifty, stocks like Cipla, ACC, Bajaj Auto, NTPC are example of stocks with Betas that are lower than 1. Such stocks may not fire on all cylinders in bull markets but hold value more effectively when the markets are down or too volatile. This is contrast to stocks like ICICI Bank and Adani SEZ which tend to have sharply higher betas and work better in aggressive market conditions.
There are no hard and fast rules for defensive stocks but essentially they are stocks that can protect value in bad times. You can surely know a defensive stock when you see one.