The run-up in the capital markets over the last 12 months has been amazing and the suspected fallout of the second wave of the COVID-19 pandemic on equity markets was temporary at best.

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On the day of penning this piece, I as an investor in the bourses along with millions of others wonder what does the future hold and what could be a potential safe haven, especially if the markets were to go into a correction and then be accompanied by a pullback. The question is can there be a defensive strategy deployed in the months ahead and if so what should that be?

So in this article, I won’t get into hedging with options and selling covered calls, (which is still a great strategy by the way) but instead talk about defensive stocks. The bell weathers always bounce back and wouldn’t give investors sleepless nights even on the wildest of times.

Stocks in sectors like FMCG, consumer durables, logistics, and pharma have remained relatively stable during previous crises; it suggests that they are safer as compared to their sectoral counterparts.

When the financial crisis struck in January 2008, Sensex lost 55 percent compared to a loss of 3 percent and 17 percent in the FMCG and Healthcare index respectively. Thus, FMCG, consumer durables, logistics, and pharma companies are always good defensive bets. The reason for their good performance during crises is that the demand does not fall in these sectors as compared to others, since they do provide essential goods and services.

What makes safe stocks safe?

Most of the companies in the defensive sectors do not solely rely on economic prosperity for business. Take a toothpaste company like Colgate, for instance. It caters to the oral hygiene space and regardless of the severity of an economic downturn , people will always need toothpaste. Therefore, it will see little to limited fluctuation in its stock price.

On the other hand, sectors like auto, banking, real estate, and infrastructure are examples of more volatile sectors during times of crisis. Buying a vehicle or a property is a decision that can be postponed if people are struggling financially.

Similarly, cyclical and commodity stocks like metal, sugar, capital goods would be the opposite of defensive. The metal index, for example, witnessed a significant downfall during the economic crisis that lasted from Jan 2008 to April 2009, delivering a return of - 122%. Since the demand for metals is directly linked to the economy, if the economy suffers this sector suffers too.

How to identify a defensive stock?

Stocks are classified as defensive based on three main parameters. They are:

Beta value of a stock

It is a measure of the stock-price change compared to the overall stock market change. For a stock to be classified as defensive, it should have a beta value less than 1. A beta value equal to 1 means that the stock price moves at the same rate as the overall market. However, if the beta value is more than one, it would mean that the stock price would move less in either direction.

Return on equity (ROE)

The average ROE for the stock for the last five years should be more than 25 percent for it to be classified as defensive.

Dividend yield

It is the ratio of annual dividend earned and the stock price and is expressed as a percentage. Usually, a dividend yield of 3-4 percent is considered good. Moreover, the company should have a solid track record of paying dividends timely to its stockholders.

Don’t get too comfortable in low-risk investments

While these defensive stocks will help you safeguard your investment during rough patches, they are not the best choice in a sustained bull run as they will underperform the market. They are, however, good for accumulating long-term wealth at a lower risk. When the market is performing well, you should consider investing in cyclical and high beta stocks, as they tend to perform better.

The best time for buying defensive stocks is when the economy is not doing too well when global crude prices are high, interest rates are high and inflation worries are coming to the fore. Since defensive stocks are not affected greatly by market fluctuations, they provide much-needed stability during turbulent times. The current rally in Indian and Global markets have defied many market gurus and those that stuck to a conservative portfolio, haven’t kept pace with the meteoric rise in metals, commodities, auto and banking stocks but if there was to be a sudden correction of 10-15 percent in the index and 20-25 percent in the midcaps, the story could be quite different.

So, if you’re one of those people looking to buy stocks today, you could keep in mind that a neutral to negative outlook may be apt for the coming few months and you can invest in good quality defensive stocks that offer high ROE and dividend yield and have a low beta.

Another important thing to consider is your risk appetite, the motto of many has been inspired by the Sony Liv show “Scam 1992” and their motto has become “Risk hain to Ishq hain”, however as an investor who has tripped up on a few bull frenzies in the past, my advice would be to lean on the defensives right now.

The bottom line is to consider the above factors before you make your choice. Happy investing!

The author, Gaurav Bhagat, is Founder at Gaurav Bhagat Academy. The views expressed are personal