The Top 10 Recession Stocks

Several months ago, when signs were starting to point to a recession, my colleague John Reeves and I compiled a list of the previous recession's top 10 stocks to discover any patterns that would help our investing this time around. That list provided a number of fascinating insights, some of which we had expected, whereas others surprised us.

While their names may have changed from a year ago, the general lessons remain the same.

Our screen looked for domestic and Canadian stocks that were valued above $250 million and traded on major exchanges -- stocks the individual American investor would have been likely to actually buy.

Drum roll, please ...
The top 10 performers since the start of the last recession are listed below, with their performances during the recession listed in the fourth column:

Data from Capital IQ, a division of Standard & Poor's.
*Duration of recession, according to the National Bureau of Economic Research.

Every one of the top 10 stocks was either a small or a mid cap. This shouldn't be surprising, as small caps not only outperform during recessions, but are also over-represented among the highest-performing stocks in general.

Last year, we were surprised that three of the top 10 stocks hailed from the energy sector -- conventional wisdom, after all, holds that energy companies would be hurt by falling demand during a downturn. This year, two energy stocks remain on the list, while technology stocks have the most representation.

Given that these computer-related firms were pummeled during the Nasdaq crash, it wouldn't have seemed the most likely area for investors to have bet on. For instance, look at the pre-recession (January 2000 to February 2001) returns for those three companies:

• Apple: -64%
• Priceline: -95%
• McAfee: -75%

The collapse of the Internet bubble made it a brutal time for many high-tech companies, so investors were justifiably panicked. But those who sold or were too afraid to buy missed out on incredible long-term growth stories.

But back to that table above. What are the major lessons from the top 10 stocks since the last recession?

1. Today's "high-tech" companies
Just as three of the top 10 recession stocks hailed from a beaten-down sector (technology), we shouldn't be surprised if there are a select few financials that will outperform over the next eight years. Apple and Priceline posted losses in 2001, so, based on a casual glance at their financials, it was undoubtedly difficult to separate them from the countless tech companies that went bust.

Similarly, there will be huge winners amid today's beaten-down financial stocks, but they won't necessarily be the big names like Wells Fargo or BB&T (NYSE:BBT). To pick the right ones, you'll need a rock-solid understanding of the business, accounting statements, and management team.

2. No time for timing
It's very difficult to accurately time sector bets. During downturns, many investors flee to "recession-resistant" industries and firms -- for example, grocers like Safeway (NYSE:SWY), electric utilities like Exelon (NYSE:EXC), and security firms like China Security and Surveillance (NYSE:CSR). It's not necessarily a bad idea to allocate somewhat defensively, but the cleverest investors don't throw all their money into a small number of industries with the expectation that they will be able to reallocate to bull-market favorites right before everyone else does.

Over the past year, each of the aforementioned defensive stocks and industries underperformed Chipotle (NYSE:CMG), Oracle (NASDAQ:ORCL), and Copart (NASDAQ:CPRT), as well as their respective industries -- restaurants, business applications, and auto retail (of all things). In addition to the unlikely energy and tech winners from the lists above, this surprise underscores just how unpredictable the market is in the short term, and thus how difficult it is to make accurate sector bets, much less to time them appropriately.

3. Still no time for timing
It's also very difficult to correctly time individual stock picks. Professors Barber and Odean confirmed this point in a massive study of more than 66,000 household brokerage accounts. The duo concluded that "overconfidence can explain high trading levels ... [which is] hazardous to your wealth."

According to their extensive data, as trading activity increased, performance declined, with the most active traders underperforming the average household by 5 percentage points annually!

In the cases of Apple, Priceline, and McAfee, investors who sold out at a huge loss or were too afraid to buy missed out on enormous gains over the following several years. And in eight of the 10 cases in our table above, penny-pinchers who waited until the end of the recession for a slightly cheaper entry price never got one.

That's why when John Bogle recently visited us at Fool HQ, he remarked that the first question each of us must ask ourselves is, "Am I an investor, or am I a speculator?" Speculators waste their energies trying to forecast short-term price movements. Investors recognize that it's impossible to know when the market will turn, so they focus on minimizing transaction costs and buying great businesses to own for the long term.

How to invest in recessions
The list above, along with the examples of the savviest investors (Buffett, Marty Whitman, Chuck Royce) suggest that the smart thing to do right now is to continue to invest in great companies at reasonable prices. The market could remain volatile and even irrational in the short run, so it makes sense to gradually add money (assuming you don't need it for the next three to five years) to the strongest companies across a variety of sectors.

That's our philosophy at Motley Fool Stock Advisor, where we focus on selecting stocks that we'd be comfortable holding for the long term. Despite launching in the midst of the last bear market, our average pick is beating the S&P 500 by more than 39 percentage points.

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This article was originally published on February 9, 2009. It has been updated.

Ilan Moscovitz owns shares of Chipotle and Apple. Apple, Priceline.com, and Copart are Motley Fool Stock Advisor selections. Chipotle is a Motley Fool Hidden Gems recommendation. Copart and Chipotle are Rule Breakers picks and Fool holdings. The Motley Fool has a disclosure policy.