Roundtable: Look for These Stocks in a Recession

Investor beware? Learn all about a down market with our recession survival guide.

Have we finally fallen into a recession? Does it even matter for investors?

With the major indexes down significantly since 2008 began, and with economic reports pointing to a slowdown in the U.S. economy, I asked Fool analysts to share their thoughts. Here's what they had to say.

1. A recent Wall Street Journal headline says it all: "Most Economists in Survey Say Recession Is Here." Though we Fools don't get into the big-picture prognostication business, what are the implications of a recession for the average investor saving for retirement or their kids' education?

James Early, co-advisor, Motley Fool Income Investor: The bad news: Stocks decline up to a year before recessions hit.

The good news: The above article notes that stocks actually rose an average of 3% during recessions. Unless you believe we're in for a Japan-style slump, prepare to buy.

Andy Cross, co-advisor, Income Investor: How's the old saying go -- "economists have predicted 20 of the past two recessions"? The media seems obsessed with calling a recession. I don't know if we are, but when Warren Buffett says we're in a recession from what he's hearing from his 70-some business managers, that's a pretty good indication. But look, recessions on average last less than a year; they don't come around too frequently; and over time, stocks go up two out of three years. So it's important that investors don't panic and sell their entire portfolios during slow economic times. Rather, use price decreases to invest in the country's, and even the world's, best companies selling at cheap prices to their long-term value.

Jim Fink, Income Investor analyst: The average recession lasts only about a year and is followed by an average economic expansion of four and a half years, so the long-term investor should not be concerned. In fact, recessions create rare opportunities to buy stocks of high-quality, blue-chip companies at bargain-basement prices. You read that right: Recessions and bear markets can actually increase your wealth over the long term if you keep buying stocks and reinvesting dividends during them.

2. If we are in or are headed for a recession, describe the type of stock investors should be looking for.

Early: Don't be a chicken when it comes to investing internationally. My very favorite way to diversify is to find solid, established companies in growing economies. And traditional havens like energy and health care make sense -- Petrobras (NYSE: PBR  ) comes to mind.

Cross: James and I try to find best-of-breed companies with unique competitive advantages that can grow through good times and bad. And of course, we look for companies that pay a nice dividend and are run by managers eager to increase it -- a company like Kraft (NYSE: KFT  ) , for example. It's the world's second-largest food manufacturer, it owns some of the best-known brands -- Oscar Mayer and Oreo cookies, to name a couple -- and it's re-energizing its operations. Or there are smaller companies, like Genuine Parts (NYSE: GPC  ) , an auto-parts wholesaler that has increased its dividend for 51 consecutive years. Now that's taking care of your shareholders.

Fink: Generally, large-cap dividend-paying stocks that cater to consumers' basic needs outperform in recessions. Specific industries that qualify include utilities (local telephone, electric, natural gas), consumer staples (food, beverages, tobacco, small-ticket household goods like soap, toothpaste, and bathroom tissue), health care (retail drug stores and pharmaceuticals), and companies dependent on countercyclical government spending (defense, public infrastructure). Selected examples from those industries include Verizon Communications (NYSE: VZ  ) , Procter & Gamble (NYSE: PG  ) , and Walgreen (NYSE: WAG  ) . And remember that just because there is a recession in the U.S., that doesn't mean that there are recessions overseas, so some international exposure through foreign stocks and U.S. multinationals always helps.

This is sort of a trick question, though, because the stock market has a mystical way of anticipating recessions six months in advance (even those that don't actually occur!), so by the time a recession has actually started, at least half of the outperformance from these recession-resistant industry groups has already occurred. For example, since the market stopped going up in mid-July, that suggests that the recession started around January. If the recession lasts the typical year, then the market will start anticipating a recovery six months in. If so, that suggests that the bear market will end in the May-June time frame, and the industries I mentioned will start to underperform. Of course, my prognostication powers could be completely wrong. (Or not.)

3. On the flip side, what type of stock should investors be avoiding in a recessionary economy?

Early: My Foolish colleague Prashant Rathore notes that tech was a lousy performer in the last go-'round, when companies such as Yahoo! (Nasdaq: YHOO  ) and Oracle (Nasdaq: ORCL  ) saw double-digit declines. He expects similar results this time. Although I think tech is cheaper today, I agree that discretionary tech spending will suffer.

Cross: You'll often hear television prognosticators recommend investing in this industry or that industry during rough economic times. But remember what I said earlier about the length of the average recession -- it's about the same as an NHL hockey season. So don't lose your long-term focus trying to time the market for the next nine or 12 months. When investors sell off powerhouses with the rest of the market, pick up some shares at discounts.

Fink: Avoid non-dividend-paying stocks, as well as those that are at risk of cutting their dividends. And with the highly publicized blow-up of Bear Stearns, I think every investor in America knows at least one industry that answers this question: financials. Other sectors include homebuilders, consumer discretionary (big-ticket items such as automobiles, vacation cruises, refrigerators, apparel, restaurants, and hotels), and industrial companies dependent on a strong economy for growth (technology, commodity chemicals, machinery, air freight, aerospace, commercial construction/engineering).

As I mentioned earlier, these cyclical industries start to outperform midway through recessions, as the market begins to anticipate better economic times ahead.

4. Historically, recessions don't last all that long -- not that that makes today's economic troubles any easier to stomach. How would you advise investors to keep their heads, with so much uncertainty in the air?

Early: A study by Fuller and Goldstein notes that dividend stocks outperform by up to 1.5% per month in declining markets. I know of many beaten-down stocks paying strong yields. Why not get paid nicely to ride out the storm?

Cross: It's not easy, for sure. It seems that every day we look at our portfolios, they are lower than the day before. To help calm your nerves, you want to own the best companies with solid financials that you can hold for a while. And a nice dividend helps, too.

Fink: Think long-term. As Wharton professor Jeremy Siegel has written, common stocks outperform virtually every other asset class over periods of 30 years or longer. Stay diversified, both by investing in many different industries that outperform at different stages of the economic cycle, and by investing in foreign stocks. Owning a big slug of high-quality, dividend-paying stocks and some fixed-income assets (bonds, for example) will reduce volatility in your portfolio by generating cash even when stocks themselves aren't appreciating. And lastly, remain focused on a stock's valuation. Buy stocks trading at a discount (i.e., margin of safety) to that valuation and sell stocks trading significantly above that valuation -- keeping taxes in mind, of course.

For theIncome Investor team's five favorite dividend stocks for new money -- and for more from James, Andy, and Jim -- test-drive the service free for 30 days. Income Investor recommendations are beating the market by nearly 8 percentage points since the service's inception in 2003, and they have an average dividend yield of 5%. Click here to get started.

Brian Richards does not own shares of any company mentioned. James Early doesn't, either. Andy Cross and Jim Fink own shares of Kraft. Petrobras, Kraft, and Genuine Parts are Income Investor recommendations. The Motley Fool has a disclosure policy.


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