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It is very fashionable for financial commentators to recommend defensive companies when the stock market is down.
A defensive company is a company that sells something that needs to be consumed; even in recessions. Pharma and Defense companies are prime examples of defensive stocks.
I don’t particularly like this idea and here is what I think.
Do we really know what defensive is?
Forbes has this story on the top items that consumers are spending on. Sales of shampoos, skin care products, grooming products, video games like NFL 09, Guitar Hero are the ones that are topping the charts, not pharma products. The rationale for this spending is – people’s desire to escape from reality (by playing video games) and the need to feel good (by appearing good). Even if you wanted to buy defensive stocks, it is hard to determine what defensive stocks are.
Do you believe the economy will never turn – around?
I waited about six months to buy a vacuum cleaner. I delayed the purchase because it was not a necessity, and I didn’t want to waste money on something that I could live without.
I believe all of you must have postponed such purchases too. When the economy turns around – these are the companies that will grow. Defensive stocks that don’t go down too much during recessionary times will not go up a great deal when the tide turns. If you really want your money to grow in stocks – you need to make decisions based on great businesses, not defensive businesses.
Will you sell off before the recession ends?
If you are invested in stocks, then you should be invested with money that you won’t need for a long time in the future. This could be two years, three years or even five years or longer. If you need cash in the near – term – then the stock market is not the right place for you. You are better off with safe investments like money market funds.
The Time to Buy Defensive Stocks is during Booms – Not Busts
When the market was booming – we had all our money in real – estate stocks. Now that they have come down by 90% or more, we are looking for safety. This is lop-sided thinking. When the market is booming, we need to get out of inflated stocks – be it in – real estate or IT. If ever it makes sense to get into defensive stocks, it is in a booming market. Now, when the market has tanked – wiping out a substantial part of our savings – investing in defensive stocks will not do any good.
McDonald’s (NYSE: MCD) is a stock that qualifies as a defensive stock. The stock was in a range of $46 – $67 during the last year. If you had bought it during the peak, you would have still been better off than most other stocks. But, if you buy it today at around $56 – what is the upside that you are looking at – when the market eventually rebounds? Not much.
Money is Made When You Buy and Not When You Sell
There is an old Dalal Street adage which goes – money is made when you buy a stock, and not when you sell it. The essence of it is – the price at which you buy a stock determines whether you will make any money on it or not.
If you buy defensive stocks that usually get fashionable in and around busts, even if they are good companies – you will not get a good price on them. Instead, focus on great companies which are building factories, recruiting talented people and spending on marketing during recessionary times. They are the ones most prepared to take advantage of a market rebound.
Buying a stock is like buying any other asset. Would you buy a car when the price goes up or down? Similarly, when the price of a stock goes down (but the business itself remains good and strong) that is the time to enter the market aggressively, and not through defensive stocks – which may turn out to be nothing more than mediocre companies in sturdy industries.
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