Recession-Proof Investing

I'm not surprised that some people think a recession is coming. But I am surprised that with housing prices falling, the credit market virtually locked up for months, and lenders still announcing billion-dollar write-downs, someone, somewhere still believes that we might avoid a recession.

So it's time to think about what stocks to own during this rough patch. The answer can be found by examining historical returns. Which stocks outperformed in previous recessions?

Growth vs. value
Ibbotson Associates compared the returns of growth and value stocks for each year since 1969. In that time period, there were a total of seven years when the economy was in recession for at least six months.

As you might expect, stock market returns were poor during recessions -- both growth stocks and value stocks had returns below their respective long-term averages of 8.8% and 11.0%.

However, value stocks were clearly the better of the two investments. Most obviously, they had better returns -- value beat growth by 3.9 percentage points. On average, value investors made money, while growth investors lost money.

What's more, value stocks achieved those results with less volatility -- a particularly important factor when you consider that during a recession, volatility usually means downside volatility. Growth stocks lost money in five of the seven years, while value only lost money in two years. In the worst recession year -- which was also the worst single year in the entire 39-year period --growth stocks lost 32.4%, while value stocks lost only 21.7%.

You ain't seen nothing yet
These results aren't surprising. Over the long term, value beats growth by about 2.2 percentage points, so you might expect that during a recession, value is likely to outperform growth. Really, the data just reinforces that you should have your portfolio in value stocks at times like these.

However, these statistics are a bit misleading, too, because the two categories were created based on mechanical screens. Thus, they included both good stocks and bad stocks, without any consideration given to the prospects of the individual businesses. So there's room for improvement.

For instance, if you had run this sort of screen in January 2007, it probably would have classified MBIA (NYSE: MBI), Ambac Financial (NYSE: ABK), Countrywide Financial (NYSE: CFC), and Downey Financial (NYSE: DSL) as value stocks. After all, bond insurers, subprime lenders, and negative amortization lenders were trading at low multiples of earnings and book value at the time. Homebuilders such as Lennar (NYSE: LEN) and Pulte Homes (NYSE: PHM) would probably also have been considered value stocks, with their strong trailing earnings and deceptively solid-looking balance sheets. Yet all these stocks were killed last year.

If you had been able to recognize back then that the housing market was overextended, you could have dodged some of these losing stocks. So, you can potentially achieve even better results than the mechanical value screen by being more discriminating. Avoid the losers and focus on the best stocks.

The Foolish bottom line
In fact, right now is an excellent time to be buying value stocks, and not just because of a potential recession. The credit and housing crisis has hit many stocks hard, even businesses that shouldn't be directly affected by these events.

Take Kraft (NYSE: KFT), a company that owns a huge portfolio of popular brands. Are people really going to stop buying Raisin Bran cereal because of current market conditions? I know I still plan to eat. Agricultural commodities have experienced some inflation, but over the long term, Kraft should be able to pass these costs on to consumers through increased prices. So it's likely only a short-term issue. Yet Kraft's down almost 20% in a few months. It's become cheap enough that Warren Buffett's buying shares.

And I don't think Kraft's even the best bargain around right now. Our Inside Value newsletter has found a number of high-quality businesses -- companies that you buy products from every day -- trading at rock-bottom prices. I'm completely baffled that people are willing to sell shares of some of these companies at such bargain prices. I'm building my recession-proof portfolio from many of these stocks.

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Fool contributor Richard Gibbons ate Raisin Bran for breakfast, since he thinks Buffett needs more money. He does not have a position in any of the stocks discussed in this article. The Fool has a disclosure policy.