How do you protect yourself from lossing money with defensive stock?
Warren Buffett once said there are 2 Rules of investing:
Rule 1: Don’t loss money.
Rule 2: Don’t forget Rule 1.
Buying great companies are always a good way to invest. But sometimes especially during the market downturn, you need to switch your portfolio to the defensive. That’s when these defensive stocks come in play.
Defensive stock is a great way for you to protect yourself against stock market crash.
All defensive stock have some unique characteristics that makes them one of the best investment to protect yourself against market crash.
Finding these special kind of stocks is actually pretty easy and I am going to show you how in this article.
7 Characteristics of Defensive Stocks
Defensive stocks have some unique characteristics that makes them one of the best investment during times of uncertainty.
Learn and understand the characteristics of these defensive stock will allow an investor to identify them during their search for great investment.
1. Boring Business
Boring business are business that don’t ever go out of fashion. Business such as Fast Moving Consumer Goods (FMCG) products, utilities etc. are just some examples.
These kind of business don’t usually makes your adrenaline rush, or the type of ‘cool’ business people love to talk about.
Almost everyone knows about them, but almost every investor will ‘yawn’ at the mention of these companies.
Simply because, these ‘boring’ business are just too normal, and some may even call it the oldies’s investment.
But just because it is the oldies’s investment, it never goes out of fashion that makes it safe investment heaven even during a market downturn.
The stock market can be up or down, but you will still need to buy your daily necessities such as toilet paper, groceries, hygiene products, or to use electricity in your home.
Your basic needs, never changes even during a market crash.
Boring business that represents our basic ‘needs’ in our life.
2. Stable Business
Stable business are business which are large blue chip companies. They usually plays a huge role in the country’s economics. These companies have been around for decades, if not centuries.
Companies such as Coca Cola, MacDonald are example of such companies. They have been around for decades and contributes greatly to the country’s GDP.
Even during a stock market crash, the investors will have confidence that these stocks will eventually bounce back.
Coca Cola for an example, have been around since 1886, which have survived the 2 World Wars and many major depressions. Not only have this amazing company have survive these major trials, the company is still growing after these hundreds of years.
Such a company give the investors great confidence that it will survive the next market crash. And these stocks can be a great place for investors to park their money in tough market conditions.
Although, they may not give you the kind of returns that some small caps and mid caps does, but they protect your downside risk beautifully.
3. Constant Demand
Constant demand is the characteristics of business that will be of high demand even when the stock market crash.
Business that are the ‘needs’ in your life.
Other than the typical FMCGs and utilities stocks, pharmaceutical companies and companies from the healthcare industry are some of the great example of these companies.
These companies gives us one of the best cushions against a market crash. They help to break the fall and protect us from losing our money.
We can choose to buy a new car later, or even to stop eating. But if we are sick, we have no choice but to see a doctor to make us well again. Such is the power of the these companies with a constant demand.
The healthcare industry is one of the best example of companies with constant demand.
Pharmaceutical companies on the other hand, is the provider of all medicine we eat, without them the doctors won’t be able to treat us.
With the demand of these companies ever increasing, they gives one of the best investment even during a bear market.
4. Attractive Dividend Yield Constant Demand
Dividends gives an investor a decent return on your investment even during a market downturn. A stock with a nice dividend yield is one of the most important aspect for a defensive stock.
With a good dividend yield, you don’t need to sell your investment to make a return. These stocks will distribute a portion of their earnings back to their shareholders in the form of dividend.
A typical stock with a decent dividend yield will be 3% to 10%. You can also check out my other article on how to find a good dividend stock.
Why do we want it to be at least 3%?
Generally, a risk-free investment such as your government bond will give you 1% to 2% return on investment. Since a stock investment will have a larger risk, you want to have at least a few percentage point higher than a risk-free investment to justify for the extra risk you will be taking.
Why not more than 10%?
This is a great question. Generally, it is ‘OK’ to buy a stock that gives a more than 10% dividend. The price of the company might have drop in price due to panic sell in the industry, while the fundamentals of the company is still sound. Which can lead to such a nice high level of dividend yield.
But sometimes, an extra ordinary high level of dividend would mean that something might be wrong with the company you are buying. When it is too good to be true, as an investor, you have to be cautious.
5. Low Volatility
Defensive stock are much lower in volatility in compared to the common stocks found in the stock market. They are not the 10-baggers or even the 2-baggers of the stock market.
They are not the ‘darling’ of the wall street.
During a bull market, these defensive stock aren’t the types of stocks that raise the most. They may raise together with the economy of the country, or the industry. But you don’t usually see a 10% increase in price within 1 day.
During a bear market, these defensive stock may drop in price by 10% to 30%, but seldom do you see them drop by more than 50%.
They have the highest resilience against a price fluctuation.
Because of the low volatility, some people especially the speculators or short term traders call them boring, and institutional investors usually ignore them.
But this is the exact reason why these defensive stock are the best investment during a stock market crash.
With the absence of short term traders and speculators, the price of the stock will be minimally impacted during the times of fear where everyone is selling their investment.
During a market crash, some stocks, especially tech companies can drop 90% in their price, which can be pretty bad for the heart.
6. Low P/E and P/B
Low P/E and low P/B are some of the most obvious characteristics of a defensive stock. This ratios are the metrics used by most investors to see if a company is cheap or expensive.
Since, defensive stocks are usually not brought by a short-term trader, speculators, or even most fund managers of the wall street. The current price of the stock is usually quite consistent to the value of the company.
In other words, the price of the stock usually consider cheap, in compared to the general market. The ‘cheapness’ of a stock is usually measured by the P/E and the P/B of the stock.
What is P/E?
P/E is the Price-to-Earning Ratio, it is the relation of the current price of the stock and the earnings the stock makes in the past 12 months.
A higher P/E means that you are paying more for the each dollar earn by the stock. A lower P/E means that, you are paying less for each dollar earn by the stock.
To understand if it is a high or a low P/E you have to know what is the historical P/E of the stock. And compare it with its historical data and the data of it’s similar industry.
Company ABC have a P/E ratio of 10. It means that, you are paying 10 dollars for each dollar earn by the company.
- Current Price (P): $10 per share
- Annual Net Income (E): $1 per share
- P/E ratio = 10/1 = 10
What is P/B?
P/B is the Price-to-Book Ratio, it is the relation of the current price of the stock and the how much the company worth. This does not includes the intangible assets of the company, such as the brand, intellectual properties etc.. Only the physical asset of the company is included in this calculation of the book value.
The book value is calculated from the equity of the company, which is calculated by subtracting the total asset to the total liabilities of the company.
A P/B of 1.0 means you are paying $1 for every $1 book value of the company.
A P/B of more than 1.0 means that you are paying more for each dollar worth of the company. You are basically paying premium to its price. The stock is overvalued.
A P/B of less than 1.0 means that you are paying less for each dollar worth of the company. You are basically paying a discount to its price. The stock is undervalued.
Company ABC have a P/B ratio of 0.9 It means that, you are paying 0.9 dollars for each dollar of book value of the company.
- Current Price (P): $0.9
- Book Value (B): $1
- P/B ratio = 0.9/1 = 0.9
7. Low Beta
The beta (β) is a measurement of its volatility commonly used to measure an investment (i.e. a stock). Beta (β) is the measurement of the systematic risk of an individual stocks in compared with the returns of the entire market.
A company with a higher beta has greater risk and also greater expected returns.
A company with a lower beta will have a lower risk and also lower expected returns.
The beta coefficient can be explained as follow:
- β >1, higher volatility than the general market
- β =1, same volatility as the general market
- β <1 but more than 0, lower volatility than the general market
- β =0, uncorrelated to the general market
- β <0, negatively correlated to the general market
Defensive stock are usually stock with β <1 but more than 0 which gives them the characteristics of lower volatility than the general market.
Such stocks may not be the ‘darling’ of wall street due to it’s lack of volatility, but they can be one of the best investment to protect against a market crash.
Smart investors will always have a few defensive stocks in their portfolio. These stock become especially important when the market is overvalued which shows warning signs of the stock market crash.
If you want to protect yourself against a market downturn, defensive stock are one of the best place to park your money.
These stock together with their unique characteristics ensure that you will be much less likely to loss half of your investment capital in the next stock market crash.
A 50% loss in your portfolio can be really painful, and I don’t really want any of my readers to experience that horror.
Thus, protect your investment with these characteristics of a defensive stock.
Here are the 7 characteristics of defensive stocks:
- Boring Business
- Stable Business Model
- Consistent Demand
- Attractive Dividend Yields
- Low Volatility
- Low P/E or P/B
- Low Beta
Next we shall look into some other articles on what to do during a stock market crash.
But before that, you can also check out some of my other articles on investing.
Knowledge is what differentiate a successful investor from a gambler. Successful investors like Warren Buffet is successful, because he have the right knowledge to make the right decision to buy or sell a stock.
Combined with the right investing knowledge and your advantages of being young. You have the potential of getting a nice profit from your investment.
Successful investors like Warren Buffett read approx 500 pages a day.
Knowledge on investment can be learn from books or articles like this one. Reading can only make you wiser and smarter, so that you too maybe able to make the right decision in your investment.
Will Durant Said:
“Education is a progressive discovery of our own ignorance.”
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Ultimate Stock Market Crash
Part 1: Signs of Market Crash
Part 2: How to Prepare for Market Crash
Part 4: How to Profit from Market Crash
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