JARGON BUSTER: DEFENSIVE VS CYCLICAL STOCKS
Roy Davidson, 26 February 2019
In this jargon buster we explain the key differences between defensive and cyclical stocks, and when defensive stocks might be preferred to cyclical stocks - or vice versa.
What are defensive stocks?
These are companies with defensive earnings – meaning earnings are not overly correlated to the economic cycle. These companies typically provide necessities that people are less likely to cut back on when times get tougher.
Examples include companies operating in the electricity and healthcare sectors. In New Zealand this includes the likes of electricity retailer and generator Meridian Energy, and pharmaceutical distributor EBOS Group.
What are cyclical stocks?
Cyclical stocks, on the other hand, are those whose earnings are much more exposed to the economic cycle. Therefore, when economic conditions worsen, these companies are much more likely to see a drop off in earnings. Conversely, in an upswing of an economic cycle, these companies should benefit to a greater extent as spending ramps up.
Examples include companies operating in the construction and discretionary retail sectors. In New Zealand this includes the likes of diversified building company Fletcher Building, and clothing retailer Hallenstein Glasson.
When may we prefer defensives over cyclicals (or vice versa)?
Unsurprisingly, cyclical stocks are preferred by investors when economic times are good and the economy is expanding at a faster rate. These companies are seen as more capable of growing their earnings as consumer and business spending improves. However, when economic conditions deteriorate, defensive stocks find favour with investors as their earnings are more resilient.
To demonstrate this point, the chart below shows the total return for two sectors in the US; consumer staples and homebuilders, from 2000 to the end last year. We can see that leading into the Global Financial Crisis, the more cyclical sector, homebuilders, outperformed consumer staples, which has more defensive characteristics. This period was beneficial for homebuilders with a strong housing market seeing strong demand for building products and construction services.
However, with the onset of the Global Financial Crisis, and the bursting of what became to be seen as a housing bubble, homebuilders significantly underperformed consumer staples. While economic conditions were tough, people continued to buy everyday necessities such as food, shampoo, and cleaning products.
With market volatility elevated at present and growth across the globe slowing, it is therefore unsurprising that investors have flocked to defensive stocks lately. This can also clearly be seen in the chart, with consumer staples again finding favour at the expense of homebuilders.