Why is it very Essential to have Defensive Stocks in ones Portfolio?
07 April 2014, Monday
There is a famous saying “Better be safe than sorry”. One cannot make too many mistakes and live to tell the tale when he is investing in the stock market. Building a safety net under one’s portfolio is very essential and its true value is realized only in a recession. Fortunately a class of stocks called defensive stocks comes to one’s aid in recessionary times. In times of plenty, bad times are forgotten but a single bad day makes one forget all the days of plenty. It may be several months before a recession blows away and defensive stocks can give one peace of mind in these bad times.
What are defensive stocks?
- One lives in recessionary times and it is time to tighten those purse strings. No more binging on parties and blowing money on movies. Time to cut down on beverages.
- Surely one would not stop having a bath or skip his medicines just because it is a recession. One is expected to continue making his purchase of soap medicines and cosmetics and stocks of these Companies remain unaffected in a recession. Defensive stocks are basically stocks of Pharmaceutical Companies, FMCG’s and even IT Stocks which come into play in recessionary times.
When must one buy defensive stocks?
- Surely the best time for one to buy defensive stocks is during a recession… Right….No of course not. At this time the bear market would have pushed the prices of defensive stocks to very high levels and purchase of these stocks at such elevated levels would result in one suffering a loss. Perhaps at the start of a bull run?
- Wouldn’t one be better served if he were to invest his money in rapidly increasing and running away cyclical stocks such as banks, infrastructure and automobiles rather than defensive stocks which appear to go nowhere at this point in time?
- The right answer is at the start of a downturn .The Bull Run is ending and one notices people all around are selling cyclical stocks and this is the time to stock up on the defensive stocks. Then just sit back and watch the prices of these stocks soar...
What are the characteristics which define a defensive stock?
- Defensive stocks are generally cheap and belong to that industry which one cannot do without. Think soap ..cosmetics...
- They may also belong to an essential category such as medicines and pharmaceuticals which one cannot do without.
- They are best sought after in a bear market but too highly valued at that time. They are best purchased at the start of a downturn or the end of a bull run when panic selling of cyclical stocks is in the air.
- One must always check the Beta value of a stock in order to identify a defensive stock .Defensive stocks have a beta value of less than one .Stocks with a beta value less than one mean that these stocks rise more slowly than the market when it is rising and fall more slowly than the market when it falls.
- These Companies should give a good return on equity with time.
- These Companies have a history of good dividend payouts mainly they give good dividends.
Getting the right mix
- Should one invest all his money only in defensive stocks? No of course not. The right mix of cyclical and defensive stocks is a must in one’s portfolio
- One could invest in defensive stocks and cyclical stocks in a ratio of 40: 60 which is a healthy mix and as cyclical stocks rise rapidly in a bull market ones portfolio rises in a booming market and is protected in a falling market.
- In a falling market the low beta stocks such as FMCG and Pharma stocks hold their own while their more glamorous cousins the cyclical stocks crash rapidly.
Comparison between cyclical stocks and defensive stocks
- A cyclical stock can have a beta value of 1.2 which means that when the market rises the cyclical stock will most likely beat the market by 20%.When the market falls this cyclical stock is most likely to fall by 20%.
- A defensive stock can have a beta value of 0.8 which means that when the market rises this stock lags the market by 20% but when the market falls this defensive stock falls about 20% less than the market.
- Earnings per share basically represents the profit after tax divided by the number of shares and is a measure of the revenue of a Company. In recessionary conditions cyclical stocks see a large part of revenue eroded whereas defensive stocks are able to weather the storm and do not see a very high loss in revenue. They are able to maintain their profit after tax and yield a higher earnings per share.
There is a famous saying “When the going gets tough the tough get going”. No where is this saying better emphasized than in the defensive stocks which hold their own in tough market conditions. If one wants to ringfence his portfolio then defensive stocks are the direction where he ought to be looking.