Investment strategy Investing in defensive stocks: What to consider?

What are defensive stocks

Choosing which stocks and industries to invest in ultimately depends on your investment objectives and risk appetite. However, in times of increased market volatility and when economic uncertainty is on the horizon, investors are likely to seek exposure to stable companies in industries providing mission-critical goods and services. As opposed to “cyclical stocks,” “defensive stocks” are meant to do just what they sound like: be defensive, AKA less likely to increase in value in broader market rallies but potentially offer some downside protection when asset prices fall.

No matter how the economy and markets are faring, defensive stocks are more likely to exhibit earnings resilience and steadier dividend payments. Defensive stocks, also known as non-cyclical stocks, are more likely to be found in certain industries, some of which include:

• Health care – One of the main reasons health care is often regarded as a defensive industry is that people’s need for doctors, medicine and medical procedures is not correlated with economic conditions. In other words, people are less likely to cut their spending on health care compared to other areas of life like entertainment, travel and clothes. As a result, health care stocks tend to exhibit lower volatility compared to other industries. Investors can get exposure to health care stocks through several distinct types of companies including hospitals, drug makers, medical device manufacturers and health insurers.
• Utilities – Similar to how people are unlikely to cut corners on health care or delay necessary medical procedures to save money, they are also unlikely to compromise on essential utilities like electricity and heating. Utilities power the nation's homes and businesses, making them mission-critical. As opposed to fast-growing and potentially more volatile companies, utilities companies typically exhibit a sense of stability given how vital their products and services are to our lifestyles in addition to the fact that their revenue streams are typically government contracted. Furthermore, utility companies might experience secular benefits due to sustainability tailwinds and reduced dependency on fossil fuels for energy, which could power future earnings for the sector.
• Consumer goods – People need essentials like food, whether the economy is expanding or contracting. Companies that make consumer staples like bread, milk, toilet paper and toothpaste also tend to show resilience regardless of how the economy is faring. These companies, which operate in a variety of industries including food, beverage, hygiene, cleaning and tobacco, are likely to have steadier cash flows and more predictable earnings when compared to other more cyclical industries.

Key considerations and risks

Defensive stocks can help you weather market volatility, but, like all other types of stocks, defensive stocks carry inherent risks. Here are some key considerations to keep in mind:

• Out of favor in bull markets – During bull markets, there is often a shift in investor preference toward cyclical stocks, while defensive stocks may take a backseat. This is due to the nature of defensive stocks, which typically exhibit slower growth rates and are less likely to experience rapid appreciation in value.
• Impact of high inflation – In periods of high inflation, defensive companies may not be able to raise dividends enough to offset the impact of rising costs, lowering the income generated from those stocks.
• Overvaluation – It is important to consider that defensive stocks may become overvalued as the demand for their protective qualities rises during a downturn in the economic cycle, making them potentially less attractive.

Bottom line

When exploring defensive stocks, keep in mind that they come in various forms and sizes across different sectors. Identifying defensive stocks goes beyond simply choosing the sector in which a company operates. For example, within the health care industry, some subsectors are less or more defensive than others. Furthermore, even within a specific subsector, not all companies exhibit the same defensive characteristics. A large, established biotech company that is already generating revenue will have a risk profile that is entirely different from an emerging biotech company with high clinical trial risk. Do your research and choose a strategy that is aligned with your investment objectives and risk profile.

If you’re looking for exposure to investments that may provide stability during volatility, defensive stocks may be worth exploring. For any questions, contact a J.P. Morgan advisor today.