Is It Time To Play The Defensive Sector?

As an equity investor, your portfolio likely spans aggressive, cyclical, and defensive stocks. But how well do you understand the power of defensive stocks in the face of market volatility? Let’s explore what defensive stocks are and whether this is the right moment to play the defensive sector 

What are the unique characteristics of defensive stocks? Defensive stocks are unique in that they are less affected by broader movements in the stock market. Their hallmark feature is low volatility, typically indicated by a beta of less than 1. This means they generally experience smaller fluctuations compared to the overall market. For instance, a stock with a beta of 0.5 would decline by only 5 per cent if the market fell by 10 per cent, offering investors stability during downturns. 

However, in periods of market rallies, this same characteristic becomes a limitation. Defensive stocks underperform relative to aggressive stocks, yielding smaller returns even during strong economic growth. Investors typically gravitate towards defensive stocks when they anticipate market corrections or when valuations seem stretched. These stocks act as a cushion, offering reliable, if moderate, returns amidst broader market volatility. Their ability to mitigate risks during uncertain times is a critical factor that seasoned investors consider when navigating unpredictable markets. 

Are the Current Valuations Overstretched?

Valuations provide key insights into the current market cycle, and it’s essential to assess whether the broader market has become expensive. Currently, the Nifty 50 index is trading at a price-to-earnings (PE) ratio of 22.5x. This multiple indicates that the index is close to being expensive but not excessively so. 

Indian markets often signal peak valuations when the Nifty 50’s PE crosses the 25x mark. In the past, such thresholds have preceded sharp corrections. For example, in early 2015, after Nifty crossed 9,000, it corrected to 6,800 as stretched valuations led to profit-taking. During this phase, defensive stocks such as FMCG and pharmaceuticals outperformed, serving as a buffer against the volatility 

Currently, the Nifty Small-Cap 250 index is trading at a PE of 29.6x, slightly above its median of 29.0x, signalling that valuations are elevated but not extreme. On the other hand, the Nifty Mid-Cap 150 index, with a PE of 42.6x, appears significantly overvalued compared to its historical median of 27.2x. These signs suggest that the broader market is expensive, while there are some pockets where valuations are at historical averages. So, caution is warranted. 

Defensive stocks are unique in that they are less affected by broader movements in the stock market. Their hallmark feature is low volatility, typically indicated by a beta of less than 1. This means they generally experience smaller fluctuations compared to the overall market. For instance, a stock with a beta of 0.5 would decline by only 5 per cent if the market fell by 10 per cent, offering investors stability during downturns. 

Industries Covered by Defensive Stocks

Defensive stocks, often referred to as non-cyclical stocks, belong to industries that offer products and services essential to daily life, thus being less sensitive to economic cycles. Some of the key sectors include: 

• Utilities: Companies providing water, gas, and electricity tend to remain resilient as demand for these services is stable regardless of market conditions. Additionally, during recessions, utility companies benefit from lower borrowing costs and minimal competition, further insulating them from economic downturns.
• Consumer Staples: This sector encompasses companies that produce or distribute day-to-day essentials like food, beverages, and household goods. Items such as hygiene products and tobacco maintain steady demand even during economic slowdowns, helping consumer staple stocks perform consistently
• Healthcare: Major pharmaceutical companies and medical device manufacturers are vital players in the defensive sector. Healthcare remains a necessity in any economic climate, making these stocks less vulnerable to downturns. 

Utilities, FMCG and pharmaceutical sectors have betas in the range of 0.4 - 0.6. These industries thrive on the premise that essential goods and services remain in demand regardless of economic conditions, making them attractive for conservative investors looking for portfolio stability 

Conclusion

From the peak of over 25,000 points at 23.5x PE, Nifty 50’s PE ratio has fallen to 22.5x. Current valuation signals indicate that the market is trading at slightly above-average valuations. The Nifty Small-Cap 250 index is hovering near its median PE, while the Nifty Mid-Cap 150 is trading at a premium. Nifty 50 hasn’t reached peak levels yet, small-cap is slightly above, and mid-cap is trading at a higher premium multiple. These valuations suggest that the market’s current state warrants caution. 

In addition, the surge in initial public offerings (IPOs) and share sales is another indication of a bull market, with high levels of liquidity and retail participation driving the stock prices upward. Given these factors, increasing exposure to defensive stocks, particularly at the right entry points, could serve as a strategic move for investors. With valuations looking stretched, defensive sectors offer a hedge against volatility while positioning your portfolio for future growth.