Should you invest in defensive companies or cyclical stocks during economic uncertainty? A balanced portfolio often contains both, but knowing which fits where is crucial. The Independent Money channel, brought to you by Trading 212, explores the differences and key considerations for investors.
What Are Defensive and Cyclical Stocks?
Defensive stocks are less likely to be impacted by economic conditions, as these companies offer essential goods and services such as food, household goods, medicines, utilities, and broadband. UK examples include Tesco, Unilever, GSK, and BAE Systems. Cyclical stocks, on the other hand, are influenced by economic growth and benefit from discretionary spending. They operate in banking, travel, leisure, manufacturing, housebuilding, infrastructure, automobile, and luxury goods. UK examples include easyJet, Burberry, Wickes, and Persimmon.
So far this year, cyclical stocks have surprised some experts by leading European and US markets, despite the Iran war impacting the global energy market. Jason Hollands, managing director at Bestinvest, notes that in the US, enthusiasm around AI and capital investment in infrastructure has driven performance, while in Europe, banks and industrial firms have benefited from resilient economic data and increased defence spending. Hollands adds that investors appear to have taken the view that the crisis will not be long-lasting.
What to Consider Before Buying
If you are worried about economic uncertainty, defensive stocks may be more suitable, as these companies are less likely to be affected. They tend to have consistent demand, predictable earnings, and cashflow, often paying consistent dividends, making them popular with pension investors. However, they may not deliver the same gains as cyclical stocks during an economic boom, but can cushion portfolios in tougher times. Defensive stocks may also experience lower volatility but could trade at a premium during downturns.
Cyclical stocks are more sensitive to changes in interest rates, inflation, and consumer spending. They may be less in demand during a recession but perform strongly when the economy recovers. Drawbacks include volatility and potential fluctuations in dividend payouts. Derren Nathan, head of equity analysis at Hargreaves Lansdown, warns that a defensive stock is not always a defensive investment, and a cyclical stock is not always risky. Overpaying for a defensive stock makes it risky, while a cyclical company priced as if the cycle will never recover may offer a low-risk opportunity.
The Impact of Your Own Outlook
Choosing between defensive and cyclical stocks depends on whether you are optimistic or pessimistic about the economic outlook. Hollands suggests owning a blend of companies via funds rather than individual stocks. For example, the IFSL Evenlode Income fund focuses on stocks with resilient, repeatable earnings and avoids highly cyclical areas. Cyclical stocks are often prevalent in value funds, such as the Temple Bar Investment Trust, which has high exposure to banking and energy.
Nathan agrees that investors should hold both defensive and cyclical stocks for a diversified portfolio. He advises taking a long-term view, focusing on companies with good management, strong financial discipline, and compelling customer propositions. Those who try to time the market may dip in and out of cyclicals, but time in the market rather than timing the market is generally more successful.
When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
