What Makes a Stock Defensive? The Ultimate Defensive Stock

This post exploring the concept of a defensive stock was written by The MoneyGardener. In the article he describes what a defensive stock is. Make sure you read to the end because he presents his suggestion for the ultimate defensive stock.

According to Investopedia.com, 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 outperform the market, however during an expansion phase they tend to perform below the market. Betas of defensive stocks are less than 1.0.

I believe there is a place for defensive stocks in every stock investor’s portfolio. What exactly defines a defensive stock, and how they are expected to behave is often fuzzy in the minds of investors. While most people normally do not think of dividends as part of the equation when discussing defensive stocks, I would argue that dividends and dividend growth certainly make good attributes of a defensive stock. If a company has shown the commitment to pay out regular, and growing sums of money to shareholders over the years this probably shows that the firm derives a fair share of its earnings from a steady, reliable source. Another way in which the paying of a dividend makes a stock defensive is because companies that pay relatively high dividends, and have show themselves to be reliable in paying and growing these dividends, will generally not fall in price as much as non-dividend paying firms when sentiment gets negative. The reason for this is due to the fact that there are droves of investors that are in search of yield; when yields rise due to falling stock prices investors will only let the shares of these dividend paying firms to fall to certain levels before they will be bought. There is usually a threshold where a good dividend paying company will have some buying support despite market sentiment or industry factors. Or course there are exceptions to this rule, as seen in the U.S. banking sector recently, but these are more serious events that happen to select companies in crisis that are usually not viewed as defensive stocks anyway. Dividend cuts in these situations are usually not that hard to see coming, as evidence in Citigroup (C) and Washington Mutual (WM) recently. When yields get up to levels that seem ‘to good to be true’ then they probably are and a dividend cut might be looming. Although, unless catastrophic earnings declines are expected this is the exception rather than the rule, and very rarely happens to defensive stocks.

So dividends are part of what makes a stock defensive, but what is the real cause of the defensive nature of a company. I believe the key lies in the term ’stable earnings’. Stable earnings are what make those dividends stable, and provides the jumping off point to make dividends grow. Stable earnings, or stable cash flow is the crucial characteristic that defines a defensive stock. Defensive stocks below to companies that receive reliable revenues and produce reliable earnings no matter what might occur in the economy, stock market, or general operating environment. Examples of stable earnings sources are consumer items or services that are staples like diapers or toothpaste, utility-type earnings such as fees for storage, fees for transport though pipelines, services that are not likely to be cancelled in any event such as cable, water, heating, phone, and electrical. There are countless other examples of stable earnings, and it is really probably a sliding scale from ‘highly stable’ to ‘moderately stable’ to ‘fairly stable’. Here are three examples of companies that I believe posses stable earnings, and thus should be considered defensive stocks:

* TransCanada Corporation (TRP) - Pipelines, power stations, and other utility-type earnings streams
* Procter & Gamble (PG) - Branded consumer products including items like shaving goods, diapers, and toothpaste
* Rogers Communications (RCI.B) - Cable, phone, wireless, and other media services.

Defensive stocks should provide some cushion when worries about economic growth loom. While they should outperform in low growth conditions, this does not necessarily mean that defensive stocks will always be 100% stable in their price action. Like any other stock, a defensive stock can get bid up to a high level for a number of reasons, including a flight to safety. When this occurs the stock is very vulnerable to high expectations and a high valuation which, when the company produces less than perfect results or investor sentiment shifts these companies can be sold off in a big way. Generally speaking though, defensive stocks should have a place in every portfolio because they will shield your portfolio from the large declines that usually occur with more cyclical type stocks when economic growth is a concern.

The Ultimate Defensive Stock

Personally when I think of what the ultimate defensive stock might be I usually think in simple terms, and about products that people use every day. While some might view tobacco company Altria (MO) as the ultimate defensive stock because of the addictive nature of its product, I am a non-smoker so I think more in terms of my day to day life. When using this mode of thinking Procter & Gamble fits the bill to a tee. This company produces products that one would still buy if he lost his job, and/or moved into a cave. Pampers, Gillette, and Crest come to mind, not to mention Tide, Always, and Folgers. No matter how bad the economy got there is always a bottom for a company that makes these products.

Disclosure: Both The Dividend Guy and MoneyGardener own shares in Procter & Gamble

(Photo Credit: Leandro Gomes Mor)