They tend to outperform cyclical stocks in hard times, but they usually are not the stocks of choice during the upswings in the business cycle. If you think of certain aspects of the three basic requirements of life (food, clothing and shelter), you have aspects of all three that comprise a defensive stock.
A defensive-stock is a stock that provides a constant dividend and stable earnings regardless of the state of the overall stock market.
Defensive-stocks remain stable during the various phases of the business cycle. During recessions they tend to perform better than the market; however, during an expansion phase it performs below the market.
Defensive Stocks are favorites by stock investors, when the economy seems to be slowing or the stock market looks toppy.
These stocks have gotten that nickname for an obvious reason...they provide a measure of protection because they provide products and services for which their is a steady demand.
The utility industry is an example of defensive stocks because during all phases of the business cycle, people need gas and electricity. Therefore, because defensive-type companies such as utilities have more consistent sales, their stocks are seen as smart investments during an economic downturn.
The food manufacturers are the true defensive plays. Alcoholic beverage companies, bottled beverage companies, and water companies are all deemed defensive stocks. People still have to drink water, kids and adults will still spend on the sodas, and it is arguable that in hard times people will drink alcohol even more.
Apartment real estate investment trusts (REITs) are also deemed defensive. Housing stocks are not defensive because there are times when the economy is poor and very little building is taking place.
The reason an apartment REIT is defensive is because of the need for shelter, and as long as these are not ultra-high-end apartments, you can imagine that if people have to live anywhere besides a homeless shelter,they will choose to live in an apartment. These also offer higher dividend income than treasury rates at almost all points of the business cycle.
Defensive stocks accommodate greed by offering a higher dividend yield than can be made in low interest rate environments.
They also alleviate fear because they are not usually as risky as regular stocks and it usually takes a major catastrophe to derail their business model.
It should also be known that most investment managers have no choice but to own stocks, and if they think times are going to be harder than normal, they will migrate toward defensive stocks.
When defensive companies start to out-perform the rest of the stock market, it could be a sign the "smart money" is playing it safe and a weaker market may lie ahead.
These stocks are most times classified in the Blue Chip Stock category.
In periods of market uncertainty, and just before quarterly earnings are released, stock investors will often park money in theses defensive issues.
But be wary, if the earnings come in better than expected, or new economic data is released as positive, cash will then exit Defensive issues in droves, in favor of more economically sensitive stocks.
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