Recession-Proof Investing

I'm not surprised that some people think a recession is coming. What surprises me is that with housing prices falling, the credit market virtually locked up for months, and lenders still announcing billion-dollar writedowns, someone, somewhere still believes 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 past 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 seven years when the economy was in a recession that lasted 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 -- also the worst single year in the entire 39-year period -- growth stocks lost 32.4%. Value stocks lost only 21.7%.

You ain't seen nothin' yet
These results make sense. 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 misleading, too, because the two categories were created based on mechanical screens. So they included both good and bad stocks, without considering the prospects of the individual businesses. So there is room for improvement.

For instance, if you had run this sort of screen in January 2007, it probably would have classified MBIA, First Horizon (NYSE: FHN), Thornburg Mortgage (NYSE: TMA), and Washington Mutual (NYSE: WM) 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 D.R. Horton (NYSE: DHI) and Toll Brothers (NYSE: TOL) 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. Stock market volatility and economic uncertainty have hit many stocks hard, even businesses that shouldn't be permanently affected by these events.

Take fashion retailers American Eagle (NYSE: AEO) and J.Crew (NYSE: JCG). These companies are suffering at the moment because of constrained consumer spending. But are these companies terminally ill, or momentarily incapacitated? I'm betting on the latter. Literally -- I own shares of American Eagle.

And I don't think those clothing companies are the best bargain around 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.

If you're interested in reading about our picks, you can test-drive the service for free for 30 days.

This article was first published March 11, 2008. It has been updated.

Fool contributor Richard Gibbons owns shares of American Eagle, as does The Motley Fool. American Eagle is a Stock Advisor selection. First Horizon is an Income Investor recommendation. The Fool has a disclosure policy.