What is a defensive business?
A defensive business is one whose sales and profits remain relatively stable during times of economic recovery and downturn. Defensive businesses tend to manufacture products or services that are essential to consumers. These products are likely to be purchased whether the economy is booming or in recession. Defensive companies tend to have a long history of surviving economic downturns.
On the opposite end of the spectrum are companies that rely heavily on a strong economy. These include luxury goods companies, which tend to do well when consumers are financially successful and feel confident.
KEY POINTS TO REMEMBER
- A defensive business is one whose sales and profits remain relatively stable during times of economic recovery and downturn.
- Defensive businesses are mostly found in specific sectors and industries.
- Most of the benefits of defensive companies flow directly from their stability.
- In many cases, their defensive nature prevents these businesses from growing rapidly.
Understanding Defensive Businesses
Defensive businesses are mostly found in specific sectors and industries. We can speak of defensive industries as well as defensive companies. Companies in the utility sector, for example, are on the defensive because consumer demand does not decline as much during downturns. Consumers need electricity, water, heat and air conditioning whether the economy is in recession or not. The other primary defensive industries are consumer staples and health care.
Defensive firms can lag behind other firms during periods of economic expansion due to stable demand for their products and services. Soaring demand for discretionary goods during economic booms can sometimes hurt defensive corporate profits.
The relative outperformance of defensive companies during an economic downturn forms the basis of sector rotation strategies. In these strategies, investors overweight and underweight sectors as the economy progresses through the business cycle.
Investing in defensive companies is generally a more profitable strategy for discouraged investors than leaving the stock market.
Advantages of defensive companies
Defensive businesses have attractive characteristics for investors, employees, consumers and national economies. Most of the benefits of defensive companies flow directly from their stability.
Investing in defensive companies often offers long-term returns similar to those of other companies, but with less volatility. More importantly for long-term equity investors, defensive companies are less likely to go bankrupt due to their relative strength during recessions. Warren Buffett often invests in defensive companies, like Coca-Cola (KO).
Employees of defensive companies have the same opportunities for promotions and higher salaries as employees of other large companies. However, they are less likely to lose their jobs during recessions due to the relative stability of their employers.
Consumers also benefit from long-term knowledge of defensive companies. Many defensive companies have been making the same products for generations. Some of their products can be found all over the world. When a consumer visits McDonald’s, they know what to expect.
Finally, having a large number of companies in defensive industries makes national economies more stable. Switzerland’s legendary stability is partly due to defensive companies like Nestlé.
Disadvantages of defensive companies
Defensive businesses also have a few drawbacks. In many cases, their defensive nature prevents these businesses from growing rapidly. In the utilities sector, they are often bound by more regulations than other businesses. In other cases, the size and influence of a particular defensive company has caused the government to restrict its activities. For example, AT&T has not been allowed to expand outside of the telephone industry for several decades.