Defensive Stocks - What Are They And Why They Could Play An Important Role In Your Stock Market Portfolio

Defensive or non-cyclical stocks are stocks which are not highly correlated with the business cycles, have in general low volatility expressed as a low beta, and many times pay a dividend. A broader definition for defensive stocks is that they are stocks with relatively stable earnings, performing well mostly in periods of economic contraction or recessions. It is important to mention that defensive sectors are healthcare, utilities, and consumer staples. Commodities are another sector which can be considered a defensive sector including commodity goods such as coffee, oil, sugar.

One of the most important features about defensive stocks is that the tend to outperform in economic downturns and underperform in business cycles such as expansion. They are stocks of companies providing goods and services considered necessary on a daily basis, and therefore are the least likely to get influenced by changes in consumer spending habits in times of economic recessions. They tend to have stable earnings, and can play an important role in any well-diversified portfolio for the following reasons:

• They offer low volatility, in general they have a low beta
• They offer many times a dividend, and can generate income for the portfolio
• They tend to be value stocks having a reasonable growth for revenue
• They can mitigate the total risk of the portfolio measured by the standard deviation of return
• Institutional investors such as mutual funds include them in their portfolios, providing support in times of economic crisis and a potential for price appreciation
• They are suitable stocks for investors with low risk-tolerance and can help to define the desired mix of asset allocation within a portfolio based on the expectations of risk and return. They can play an important role in the diversification of the portfolio.

A defensive stock is not a stock of a company having recently filed for an IPO but are well-established companies with a long history. It is not hard to find defensive stocks using a stock screener. Some basic characteristics are:

• Strong and positive cash flows
• Dividend yield history
• Relatively low financial ratios such as P/E, Price/Book Value
• A moderate but sustainable growth for revenue and earnings
• Large capitalization

Applying a top-down financial analysis approach for selecting defensive stocks is not only important but also very topical now, as many financial analysts believe that the US economy may enter in a period of economic slowdown. Even a global economic slowdown is discussed. In this economic framework an investment strategy with emphasis on minimizing the risk of the total portfolio can include several defensive stocks from different sectors to offer both diversification and generate income in terms of dividends.

While defensive stocks are considered less volatile stocks compared to the stocks of technology sector, they have the potential to offer both capital gains and enhance the total return of the portfolio offering an attractive dividend yield. In the most recent 10-year bull market of the US stock market the defensive stocks have mostly underperformed the stock market but taking into consideration the dividend yield and any price appreciation with low volatility is a strong argument in favor of them.  

Two defensive stocks that investors can analyze and potentially add to their stock market portfolios having solid financials and being attractive at current price levels are Cigna Corporation (NYSE:CI) and United Health Group (NYSE: UNH).