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]
15 thoughts on “Defensive Stocks: A Investing Strategy For Mr. Market’s Bad Mood”
Funny you mentioned WM. Bought WM around 2009 or so and the stock has performed quite well in the last 10 years. Held on to it because I thought, “hey ppl need their garbage removed in bad times and good times.”
Like you said, market timing is pretty damn difficult, better to just buy and hold.
As a customer of WM, I really wish you wouldn’t have done so well … my garbage bills are crazy high! 😉
Interesting stuff here Mr Tako! Couple little surprises too. Glad you like doing your research 😉
I’m a big fan of the Scott Burn’s couch potato portfolios.
Thanks for all of your great research Mr. Tako! I am close to FIRE number, so at the moment keeping the stable reliable job and socking it away. I was just away on vacation for a week, and heard about the yield curve inversion, my pulse quickened for a second, then I shrugged and lay back down on the lounge chair : ) possibly with a beverage. My biggest thought was about whether there would be a sell off, and I could buy vanguard funds at a nice discount : ) : )
It sounds like you’re getting really close to FIRE if those are the thoughts that cross your mind! 🙂
Healthcare looks good to me. The population is aging and we need more healthcare.
I checked the chart and VHT did pretty well against the whole index over the last 10 years.
I don’t see the underperformance. Did I look at the wrong thing?
The under performance of healthcare depends upon the dates you pick. In the last 4 years it’s under performed the index, but it’s so close it really depends upon what dates you pick.
In decades past, healthcare was a growth sector, but I’m not sure it’s fair to call it that now.
I think the problem many people get themselves into is they just buy a stock because it sounds good, and they believe it to be defensive. You really need to examine the underlying business. Who cares in the short run how the stock does. Is it a good business? How is the business set to perform for the next 5 years? 10 years? I bought MCD (McDonalds) a number of years ago when it took a dip from over a hundred dollars to the high 80’s. In bad times, people eat off the dollar menu and skip out on going to Chilli’s or Steak Houses. In good times, people eat out more often and some of those visits will probably be to McDonalds (even though no one but kids really likes it). The stock is now nearing $190. Don’t just buy a health care stock or utility stock because it sounds good. Examine its actual business. What are its revenue growth predictions? Is the business expanding? If the business is good, the stock price will usually reflect that at some point. Unless you’re a day trader, don’t invest based on stock price volatility. Research the underlying business.
Take Healthcare discussed above. An individual company may do really well and be a good investment, but many of the healthcare companies might actually underperform. Expenses for doctors and nurses and equipment, etc… go up, and because rates charged to patients have to be approved by the government or insurance agencies, a specific healthcare sector may not be able to have a corresponding increase of income to cover the increase of expenses. In my opinion, there is a little bit of a backlash against the rates being charged by health care providers right now.
I made the mistake you are talking about a few years ago. Many of my stocks were too defensive, and my portfolio lagged the overall market during upswings.
Nice reminder that not all stocks are equally ready for a downturn.
I always thought my SCI (Service Corp International – funeral / cemetery business) would be defensive, but I guess funeral expenses are a bit more elastic than garbage or utilities 🙂 At least it fully participated in the recovery!
That is odd… I would have thought SCI would be considered a defensive stock too. Afterall *everybody* is a customer sooner or later. If you’ve held it since 2008, then you’ve definitely done very well!
Another great example of what owning good business can do for a person’s net worth! Thanks Paul!
Nicely Explained! I am a big time lover of value investing. Mr. Tako your defensive stocks investing strategy relates more like value investing to me. And yes not all stocks are created equal.
Hi – my approach to retirement investing – regardless if in a growth economy or in a recessionary economy or potentially at the stage of heading into a recession – continue to dollar cost average into the S&P 500 index. If I had more time, I wouldn’t mind researching defensive stocks. But I just find looking and monitoring new stock investments to be too time intensive.
As usual, great research and analysis that is hallmark of your posts, and generally built into your life, I think.
As usual, most people first of all can’t, and even if they do, won’t be able to get into the depth that you explore into. Even if they manage to reach the depth, the don’t need to! As you concluded your post with, the vast majority of people will be just fine if they invested in broad-market based funds.