All economies experience recurring and fluctuating levels of economic activity over a period of time.
The five main stages of the business cycle are: growth, peak, recession, trough and recovery. At one time, business cycles were thought to be extremely regular, with predictable durations, but today they are widely believed to be irregular, varying in frequency, magnitude and duration.
The business cycle tends to be replicated in the stock market with the market going up when the economy is growing and going down when it is contracting.
DEFINING DEFENSIVES
What is a defensive? Also known as a non-cyclical stock because it is not highly correlated to the business cycle, it is essentially a firm whose revenue and profit are not overtly impacted by the state of the economy - largely because demand for its products or services is relatively unchanging.
Tobacco, pharmaceutical, consumer goods and utility firms all fall into this category to greater or lesser degrees. Utility companies should have particularly stable profits because their revenue is essentially determined by independent regulators which lay out what they can charge for water, gas or electricity.
Because revenue and therefore profit and cashflow is stable, defensive stocks are usually in position to maintain a consistent dividend policy - offering shareholders a regular and secure income.
RECESSION RESISTANT STOCKS
These qualities allow them to perform better than the market during a recession. Shares in consumer goods giant Unilever (ULVR), for example, increased in value by 24.1% through the 2008/9 recession. Which in the UK ran from the third quarter of 2008 through to the fourth quarter of 2009.
By comparison the FTSE All Share index fell 7.2% over the same period. The company manufactures everyday brands such as Lynx, Domestos and PG Tips and demand for these household basics is more resistant to an economic downturn.
One way to measure how defensive a stock is, is to look at beta.
Beta measures by how much a stock moves when the overall market risers or falls by 1%. If a company has a beta of 1.5, the shares will, on average, shift by 1.5% for every 1% change in the market but a beta of 0.5 means it would budge just 0.5% for every 1% move. Low beta stocks should in theory help protect your portfolio during periods of increased volatility.
WHAT ARE THE DOWNSIDES?
The downside is that defensives will typically underperform when markets are rising as, unlike firms which are more in synch with the business cycle such as airline operator International Airlines Group (IAG), they will not experience a significant upswing in demand as the economy recovers.
