INSIGHTS

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, travel and discretionary retail sectors. In New Zealand this includes the likes of diversified building company Fletcher Building, Air New Zealand 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 growth in earnings per share for two sectors in the US: consumer discretionary and consumer staples. We can see that earnings for the defensive consumer staples sector have been less volatile than for the consumer discretionary sector. This reflects that fact that when economic conditions are tough, people continue to buy everyday necessities such as food, shampoo, and cleaning products, whereas spending on non-necessities/more luxury items like eating out, travel or upgrading to the latest phone or car are put on hold.

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.