How to Invest When You Expect the Worst

This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.

It's always darkest right before dawn. But a lot of the time, it seems pretty darn dark right before it gets even darker.

The global economic scene isn't pretty right now. Whether it will improve or deteriorate from here -- and to what degree and how fast -- isn't my concern today. I am writing for one reason: To share what I would do if I believed we are headed for hell in a handbasket.

1. Choose companies that don't rely on capital markets
The best business model in the world won't keep a company out of the gutter if it relies on volatile capital markets to fund its operations. Capital markets -- even those that seem endlessly liquid, such as the corporate debt market -- can quickly turn Saharan-riverbed dry in a financial panic. Companies with massive debt, large near-term debt maturities, or a habit of simply rolling debt out rather than meaningfully repaying it will quickly find themselves struggling to survive -- regardless of the strength of their underlying business. Suddenly, the massive cash balances harbored by companies like Apple (Nasdaq: AAPL  ) and Google (Nasdaq: GOOG  ) won't seem like such a bad idea. If you think we're heading down, look for companies that could easily operate for the next decade (or, even better, forever) without capital markets.

2. Opt for uncorrelated investments
If we learned anything in 2008, it's that in a downturn, correlations among investments all approach one. The last stock you want to own during a global downturn is one that is closely tied to GDP. I wouldn't be satisfied unless my stocks were uncorrelated not only with the economy but also with each other. Correlations will jump in a crash; I would proactively maneuver to mitigate that fact.

Unfortunately, most businesses are fairly tied to the overall economy. But with over 50,000 publicly traded companies on worldwide exchanges out there, you only need to own between 10 and 20 or so (or at least that is my general preference). Look for the uncorrelated stocks -- such as cemetery owner and operator StoneMor Partners (Nasdaq: STON  ) , which I own both personally and in my Rising Stars portfolio. It doesn't get much less economically correlated than cemeteries.

3. Head south ... far south
The U.S. might be heading toward recession. Europe is likely a slow-moving train wreck -- and the collision has the potential to reverberate around the world. China, besides its corporate governance issues, may be one huge bubble -- and Australia's economy is predicated on that bubble.

I can't believe this day has come, but Latin America seems to be the only major economic region that isn't contributing major problems to the world economy. That's not to say that the region doesn't have problems -- political, social, and business issues are the name of the game anytime you go below the 30th parallel north. But these issues are nothing new; at the moment, Latin America is merely reacting to major global economic issues rather than creating them. On top of that, Latin America is showing impressive per capita income growth and has a young population rapidly coming of age. That spells opportunity for companies like PriceSmart (Nasdaq: PSMT  ) (the Costco of Latin America) and Companhia de Bebidas das Americas (NYSE: ABV  ) (the Budweiser of Latin America).

4. Look for catalysts
In a world where correlations approach one and valuation matters more than ever, I'd want investments with an identifiable catalyst that will unlock the value in a stock. Whether it's a dividend hike, spinoff, earnings report, turnaround, or one of various other possibilities, I'd want a clear incendiary event driving my investments toward their fair value.

I've been looking at a number of catalytic investments lately and expect to buy a certain one next week in my Rising Stars portfolio. If you'd like to ensure you catch that, I recommend you follow me on Twitter -- that's the best way to keep up with my trades.

5. Hedge
If you don't like the premise of a question, reject it. Instead of asking, "Will this stock go up?" ask, "Will this stock outperform the broader market?" Change the nature of your bets by shorting broad-market ETFs such as the SPDR S&P 500 ETF (NYSE: SPY  ) , which tracks the S&P 500, or the iShares Russell 2000 Index (NYSE: IWM  ) , which tracks the small-cap-focused Russell 2000. If you short 100% of your long stock exposure with index ETFs, you will isolate your ability to select stocks that will outperform the broader market. You'll pick up the difference between your stocks' performance and the market's performance -- so if the market is down 15% and your individual stocks are only down 10%, you'll still make a 5% return.

Invest better
Whether this is a temporary dip or we're in for a lengthy period of economic pain is still to be determined. If you believe it's the latter, this is how I would recommend you invest.

Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.

Follow all of Alex's trades and musings on Twitter.

Alex Pape owns shares of StoneMor Partners. The Motley Fool owns shares of StoneMor Partners, Apple, and Google, and has sold short shares of SPDR S&P 500. Motley Fool newsletter services have recommended buying shares of Apple and Google, creating a bull call spread position in Apple, and shorting iShares Russell 2000 Index. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On October 10, 2011, at 5:20 PM, FutureMonkey wrote:

    I tend not to play defense with individual stocks, since even the safest looking stock could suffer an unforeseen tragic event that tanks the market value relative to the competition in their segment of the market. I like individual stocks for growth and ETFs with a large basket of stable dividend players for my defense position. In fact one of my largish positions in 2011 has been DEF (ETF by Claymore that focuses on dividends). This adds ballast to my otherwise volatile portfolio.

    FM

  • Report this Comment On October 11, 2011, at 7:52 PM, wigan4 wrote:

    I use regulated utilities for the same purpose. I think you get the same lack of correlation--or at least a very low coefficient--and much better yield.

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