At first glance, the appeal of ASX defensive shares is obvious. After all, who wouldn't want to own a company that is at least partially immune from the stock market volatility that terrifies so many investors?
A defensive share is usually defined as a company that operates in an industry resistant to economic maladies. It's a company that can continue to sell a product or service in good times and bad, during recessions and booms, in times of high inflation or deflation.
But defensive shares don't always make for good long-term investments.
A good example is energy generator and retailer AGL Energy Limited (ASX: AGL). As a utility stock, AGL appears to fit the defensive bill nicely. Everyone, be they individuals, businesses or governments, needs electricity (and possibly gas) to live and function in our modern society. And usually, we have no choice but to accept the prices that our energy retailer foists on us.
That should mean AGL, the largest energy utility in the country, is a top defensive stock. But an investor who bought AGL shares five years ago would today be down on their position by 41.4%. The dividends from this 'defensive' company would only partially reduce that loss.
Finding the right defensive shares on the ASX
So how does one find a good quality defensive share? Well, here are two things I look for when shopping for defensive ASX shares.
One of the many reasons AGL shares have struggled over the past few years is a tough regulatory environment. Power and gas prices can be influenced by government regulations. Further, AGL also (rightly) faces enormous pressure to reduce its greenhouse gas emissions. These two frameworks are arguably a costly burden for the company and its shareholders.
Many other defensive shares have to operate within regulatory frameworks too. But not all are so deleterious to a company's prosperity. One of my favourite defensive shares is Transurban Group (ASX: TCL). Transurban operates the largest network of tolled roads in Australia. It is restricted in what it can charge motorists for the use of its tolls.
However, Transurban has made sure that inflation protections and predictable toll rises are built into its pricing structures. This is the kind of regulatory environment that favours a company.
It's a similar story with another of my top defensive picks Lottery Corporation Ltd (ASX: TLC). Lottery Corp runs most of the lottery and Keno services in Australia. It holds exclusive, quasi-monopolistic licenses in almost all states and territories that allow it to operate without competition. As such, I think it is another top defensive share that has the potential to outperform the broader market over time.
Selling something we can't live without
A third defensive share to consider is Coles Group Ltd (ASX: COL). We would all be very familiar with how Coels operates as a grocer. While this company doesn't really face the same regulatory issues as Transurban, AGL or Lottery Corp, its consumer staples nature means that Coles can boast a highly defensive earnings base.
At the end of the day, we all need to constantly eat, drink, and stock up our households with life's essentials. As long as Coles is a low-cost and convenient place to have these needs met, its business will be largely immune from economic downturns, inflation, and most other commercial storms that can cripple other ASX shares.