Defensive Stocks: A Investing Strategy For Mr. Market’s Bad Mood

Once upon a time and not so long ago, I told a fairy-tale about Low Beta investing.  It’s one of those great investing fairy tales backed up by plenty of research which attracted lots of attention and money.  When I looked at the actual results of the strategy, it didn’t fair so well.  It made for a good bedtime story however.

Fortunately, there’s plenty more investing bed-time stories where that came from!  Today we’re going to look at one of the classics — a equity investing strategy used to protect the investor during recessions and other market downturns.  It’s called “Defensive Stock Investing”

This particular fairy-tale tells the story of an investor who buys into a defensive stock of the economy when the big bad bear shows up, and manages to protect his or her portfolio from the downturn.

What Are Defensive Stocks?

Defensive stocks are traditionally considered “recession resistant”.  Notice I said “resistant” not “recession proof”.  Almost any business can see *some* economic downturn during a recession, but defensive stocks are generally considered more resilient than your average business.

These stocks are the well defended castles of the investing world.  With wide moats and thick stone walls, these castles can withstand many a economic attack.

The idea is that investors buy into these stocks and funds to protect themselves against stock market declines.  When the market goes down so do defensive stocks, but they go down a little less than average and thus protect the investor’s gains during a recession.

A classic example of a defensive stock might be Waste Management (Symbol: WM), a garbage collection and recycling company.  People pay to have the trash picked up regardless of whether there’s a recession or not, and in many municipalities WM is the *only* garbage collection provider.  This makes WM a very resilient stock for investors looking for a little protection during a downturn.

How did Waste Management fair during the last recession?  Check it out:

What if garbage stocks are not really your type of investment? Well, one of my favorite defensive stocks (that I’ve covered in a past post) is Computer Services Inc. (Symbol: CSVI)  It’s a bank software provider.  If you consider the fact that many banks were going out of business during the 2009 recession, you’ll realize what a incredibly solid business CSVI is.

This is what it is to be a defensive stock.  When the going gets tough, they just keep-on going.  When the general market declines, they might decline only a little, but investors come back when they realize what a strong business it is.

Defensive stocks aren’t perfect though.  In bull markets they can often under-perform the S&P 500 when the money finally comes flooding back into the market.  Let’s use CSVI again to illustrate this point:

It’s a fascinating puzzle that really illustrates how much money flowing in and out of the stock market can alter performance.  All those cash flows can wildly effect investor returns!

Other Defensive Sectors

It’s not just banking services and garbage companies that are considered defensive investments, there’s plenty more where that came from!  There’s whole sectors of the economy that are considered defensive.  Rather than trying to suss out good individual stocks here, it’s probably easier for interested investors to just buy the whole defensive sector using an ETF.

Here’s a few of the more popular defensive sectors that I know of:

Electric Utilities — Fortunately for utility stocks, people don’t stop using electricity during a recession.  Utilities have traditionally been considered very defensive “safe” stocks, but unfortunately they just don’t perform terribly well.  This is one of the reasons why I dislike utility stocks.

Here’s how the Vanguard Utilities ETF (Symbol: VPU) performed against the S&P 500 during the last recession:

Healthcare Stocks — Healthcare is another area that’s considered a defensive sector.  From drug makers to healthcare facilities, this is a very large sector of the economy that doesn’t just “slow down” because the rest of the economy is slowing.  People still have babies, get sick, and need medicine.  This means healthcare stocks make for a very defensive sector of the economy.

Here, we can see how the Vanguard Healthcare ETF (Symbol: VHT) performed fairly well against the S&P 500:

Aerospace & Defense Industry — When the economy gets in a slump you can always count on the government to keep spending.  Much of that spending happens in the aerospace and defense industries.  After all, the government still needs fighter jets and aircraft carriers even during a recession…  So, the story goes that aerospace and defense sectors are going to do pretty well during recessions.

How do the real world numbers match that theory?  Let’s compared the iShares US Aerospace & Defense ETF (Symbol: ITA) against the S&P 500 during the last recession:

Consumer Staples — Last but not least is the consumer staples sector.  Consumer staples are goods that people are either unwilling or unable to cut from their budget during a downturn.  Household goods like soap, toilet paper, frozen food, and beer make up consumer staples (as opposed to consumer discretionary items).  According to the popular “defensive stock” theory, such stocks should outperform during market downturns.

How did consumer staples fair during the last recession?  Using Vanguard’s Consumer Staples ETF (Symbol: VDC) you can see for yourself:

At a first glance, it might seem like investing in these defensive sectors would be a great way to outperform the S&P 500 — Pivot into defensive stocks before a recession to see a much smaller decline.

Unfortunately this strategy fails to tell the whole story.  There’s a fatal flaw in this defensive strategy —  Over a long period of time, most defensive sectors fail to outperform a simple S&P 500 index fund.  Sure, they might outperform during the downturns (like I showed above), but if you stretch that performance time period out further to include market upswings, you’ll begin to see under performance.

Consumer staples is this way, Healthcare, Utilities… the only exception to this under performance trend was the Aerospace and Defense sector.

When The Fairy Tail Meets Reality

When I first came up with the idea for this blog post, I had no idea how defensive stocks or defensive sectors might perform over the whole economic cycle.  I just like researching these things.

What I found was a very nuanced story — During the downturns, yes, defensive stocks tend to out perform.  But over the full economic cycle (assuming we’re at the top of the upswing now), sector funds generally under performed.  This implies that investors who desire to capture some of that market out-performance during a recession would need to ‘dance’ in and out of the defensive sectors at just the right time.

I don’t know about you, but all that market timing is not really something I have a skill for.

While it is true that the S&P 500 index fund displays greater volatility than defensive sectors, the reality is that investors who manage to just hold on to a broad index fund through the full economic cycle have historically see better performance.

This is just using a simple buy-and-hold approach.  If you’re interested in more advanced defensive stock strategies, Vanguard has a well researched paper that covers defensive stock strategies and their associated results.  After reading through that paper, I believe that trying to capture those gains is incredibly difficult.

Most investors would seem to be better served by just accepting the greater volatility of broad market index funds, rather than trying to getting fancy with defensive stocks.  If the investor is properly prepared for a recession, just holding a simple index fund through the big swings will do pretty well.   Selling assets during the downturn should not be necessary.

With that strategy in mind, market volatility really becomes a non-event.  Like flipping through television channels on a TV — You know there might be a scary movie on another channel, but you don’t have to watch it.

[Image Credit: Flickr]