Economists and indicators agree on one thing: the recession is approaching and investment in stocks has already confirmed this in recent months, especially after the Fed raised interest rates again on Wednesday. So let's assume it's a sure thing and start preparing our portfolios accordingly. Let's define what the best recession-proof stocks have in common and pick the ones that fit the bill.
What do recession-proof stocks have in common?
Investing in stocks with a recession-proof business model
The first thing we want to see is that demand for a company's products and services will remain resilient if the economy enters a recession. For example, an investment in shares of companies that sell everyday items at a discount, or a solar company operating somewhere with ambitious renewable goals.
When looking for recession-proof businesses, the following industries are a good starting point:
- Public services: People still need heat and electricity in a recession.
- Consumer staples: People still need to eat, drink and brush their teeth.
- Medical care: People still need to take care of their health.
But we don't have to limit ourselves to looking at these industries. We can find hidden gems even in cyclical industries, like the ever-growing pizza chain Domino's.
Sectors that make up investment in defensive stocks. Source: WallStreet Mojo
Likewise, not all utilities, commodities, and healthcare companies have recession-proof business models: WalMart doesn't sell only commodities, for example, so its margins could still take a hit in a recession. That's why it's important to do your homework and look at all the criteria for recession-proof stocks.
Investing in stocks with stable dividends and buybacks
Investing in dividend stocks with good yields tend to outperform the broader market when interest rates are rising, when inflation is high, and when economic growth slows. As for buybacks, they indicate that management not only believes the share price is cheap, but will also help support prices by reducing the number of shares available and therefore grow earnings per share.
Profitability of stocks without dividends vs. with dividends. Source: VanEck
Investing in stocks with strong balance sheets
When everything goes wrong, the last thing we want is to make an investment in stocks of companies that have high operating leverage, because a small drop in revenue can cause a big hit to profits. High financial leverage can carry many risks, including not being able to pay debt, which jeopardizes the integrity of the company.
A good tool to estimate the probability that a company will go bankrupt is the model Altman Z-Score, which uses five key financial ratios. A measure above 3 indicates that the company is safe, while any measure below 1,8 indicates possible problems in the near future.
Explanation of the Altman Z-Score model. Source: Corporatefinanceinstitute
Investing in stocks with stable earnings growth
We should look to make our stock investments in companies that are growing consistently, and regardless of how the economy is doing. Therefore, we need to analyze each company's earnings growth over time:
- How consistent is it?
- Does it tend to fall when the economy is not doing well?
And above all, we have to avoid making our investment in shares in companies that tend to experience large declines and invest in those that show constant and stable growth for several years. We also have to make sure that earnings forecasts for the next two years are solid, or at least not too far below the market average.
Investing in Cocacola (KO) stock for the long term is a great value investment. Source: Yahoo Finance
Investing in stocks with low volatility and beta️
The lower a stock's volatility, the less likely it is to fall if markets stagnate. Of course, since we're in a unique environment, looking at a stock's history may not be enough, so we have to make sure to also check its implied volatility, which you can see at Barchart. It will show you what investors expect the future volatility of the chosen stock to be. Ideally, we want to see low historical and implied volatility.
Apple Options Data Summary. Source: Barchart
Looking at a stock's beta can help you estimate how sensitive it is to changes in the broader market. A beta of 0,5 suggests that if the stock market loses 10%, the stock would fall about 5%. The measure is not perfect, but it provides a quick way to estimate how defensive a stock is. It can also be useful in identifying potentially defensive companies. For example in finviz We can also visualize the companies with the lowest beta.
Investing in stocks with a reasonable valuation
Valuation is useful because it measures a company's “margin of safety.” Instead of simply looking at whether a stock is trading at a premium or discount to the market, we have to look at how it is trading compared to its own history. Strong, defensive companies tend to trade at a premium to the market in all conditions, but can trade below their long-term average when stocks are struggling. Tradingview It has a section that allows us to see the valuation of different assets.
The Tradingview tool is very useful for deciding where to invest in stocks. Source: Tradingview
Which stock investments make the cut?
The manufacturer of Marlboro Altria (MO), the beloved producer of personal products Colgate-Palmolive (CL) and Coca-Cola's nemesis, PepsiCo (PEP), are three consumer staples stocks that score solid on most measures.
And in consumer discretionary stocks, two currently look attractive by our standards: auto parts retailer O'Reilly Automotive (ORLY) and the pizza maker Domino's Pizza (DPZ).
In other sectors, the regulated electric service company Xcel energy (XEL), healthcare stocks Cardinal health (CAH) and Quest Diagnostics (DGX), the railway operator Union Pacific (UNP) and electrical manufacturer Hubbell Incorporated (HUBB) also seem quite attractive based on the attributes we were looking for to make our investment in stocks.