Investing in the stock market during a recession, or preparing a recession-resistant portfolio, often means rethinking which stocks to own.
Amid the coronavirus-inspired stock market meltdown, investing for value can be an attractive option if you are on the hunt for bargains.
Downturns are painful, says David Iben, chief investment officer at Kopernik Global Investors in Tampa, Florida, but there is a positive side effect. “They’re the time when good companies are often sold at too low a level by panicky sellers,” he says. “This is when they become ‘value’ stocks.”
Traditionally, a value investing strategy revolves around finding stocks that are undervalued by the market at large. Value stocks can be some of the most high-quality investments in a recession portfolio, potentially outperforming growth stocks.
“When economic growth is down, growth stocks can’t go up,” says Jason Laux, vice president of Synergy Group in White Oak, Pennsylvania. “Value stocks capitalize on the down market and find opportunities at sale prices.”
Here are three tips for knowing how to identify the most promising value stocks in which to invest during a recession:
— Focus on fundamentals.
— Hedge against the downside.
— Avoid value traps.
Focus On Fundamentals
Comprehensive analysis is an important part of developing a bear market investment strategy. That means looking under the hood of prospective value stocks to see how the engine is running.
“Periods of elevated volatility can create opportunities when stock prices diverge from company-specific fundamentals,” says Dan Eye, head of asset allocation and equity research at Roof Advisory Group, a division of Fort Pitt Capital Group. “However, investors shouldn’t deviate from their investment process because of larger-than-normal market swings.”
That means evaluating value stocks based on a company’s underlying strengths and weaknesses. For instance, research its management team, business model, cash flow, assets, liabilities and the demand for its products and services, both in and out of a recession.
“Focus on the companies that are not only strong enough to weather the storm but will also come out stronger on the other side,” Eye says.
Though past performance is not always a guarantee of what the future may hold, it is also helpful to consider a value stock’s track record, Laux says.
“Do your research to see how specific value stocks have performed during previous recessionary periods,” he says. This can give you a baseline reference to compare when investing during a recession.
Aside from overall performance, consider the stability of a dividend-paying value stock’s distributions.
“A good measure of financial strength is a company’s dividend history,” says Bill Fitzpatrick, managing director and portfolio manager at Logan Capital Management in Newtown Square, Pennsylvania. “If a company has maintained or increased its dividend through previous recessions, that’s a good sign.”
Hedge Against the Downside
Value stocks could prove profitable as part of a recession investing strategy, but it’s still important to manage risk in your portfolio.
“Investors should be seeking downside protection,” Fitzpatrick says.
He says you can do that by not overpaying for a dollar of earnings or cash flow and looking for cash-rich companies with minimal debt. Choosing large-cap stocks could also give you an edge if those companies have the financial flexibility to remain solvent during an economic downturn.
Choosing the right sectors to find value is important, too, for finding the best investments for a recession.
Anthony Denier, CEO of Webull, equates value investing in a recession to finding the hidden gems at a garage sale. “Value investors want stocks with a share price lower than the company’s book value,” he says. “Many of these companies are found in defensive sectors, such as consumer staples, utilities and telecoms.”
Denier says these sectors could be a natural choice for value investing during a recession because they cater to consumers’ essential needs. “When the dust settles, value stock hunters want to see strong earnings growth, a low price-to-earnings ratio, a solid balance sheet, sufficient free cash flow and, preferably, a dividend.”
Avoid Value Traps
A value trap occurs when a stock that appears to be undervalued turns out not to be. This type of scenario can develop when a company has all the hallmarks of a value stock — such as a low price-earnings ratio, low price-to-book ratio or a high-yield dividend — but its performance and growth have plateaued.
Value traps can be costly for investors who are looking to buy stocks at a discount during a recession. So it’s important not to get caught in one, says Carlton Neel, CEO of Chaikin Analytics.
“We believe the term ‘value’ can be interpreted in many ways,” Neel says. “We prefer to focus on earnings consistency and high free cash flow, rather than just simply looking for stocks that appear cheap on a price basis.”
What that means: Do not allow yourself to be deceived by a low cost-per-share price. One simple way to tweak your recession investment strategy to help avoid value traps is by investing in funds versus individual companies.
“Investors should consider categories of value stocks rather than individual value stocks,” Laux says. “Category value stocks like value ETFs and value mutual funds inherently decrease your portfolio’s risk, potentially protecting it from market volatility.”
Given the U.S. economy’s cyclical nature, downturns and stock market sell-offs should not surprise investors, Fitzpatrick says. Investors should be looking for opportunities to revisit their capital allocation and rebalancing as needed to align their portfolios with their risk tolerance and long-term goals.
The silver lining of investing during a recession is that they do not last forever. From a value investing perspective, it is helpful to look ahead to anticipate how you may need to pivot once the economy begins to regain steam.
“Coming out of a recession, there is a time when growth stocks start to pick up and value stocks will decline, Laux says. This is when you need to be in tune with what is happening in the market and how momentum is trending.
It is a good idea to think about your portfolio as a whole, he says. “If you bought more value stocks during a recession, make sure that you rebalance so you aren’t overly concentrated in value stocks.”
Also, consider your cyclical stock exposure if a recession appears to be waning.
“At some point, investors who piled into defensive sectors will need to reassess their exposure to cyclical stocks,” Eye says. “Cyclicals tend to lead the market on the way out of a recession and they tend to start leading the charge before the economic data turns positive.”
Finally, do not feel pressured to overcommit yourself to stocks purely for the sake of chasing value.
“Investors should be cautious and keep equity exposure to their ‘sleep at night’ levels,” Neel says.
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