Since the Great Recession enveloped the global economy back in 2008-09 related to a crisis with sub-prime mortgages, there has not been any real indication of a similar crippling economic downturn returning for over a decade now. But that doesn't mean a recession couldn't return.
And while no one should expect to invest with the looming fear of an impending recession, it's always good to position your portfolio to be ready for one. The key is not to over-prepare, but instead to ensure the portfolio is continually reviewed and positioned in case of unforeseen circumstances. Investors can view these practices as a form of insurance for their portfolios.
Here are three effective ways to prepare your investment portfolio for a recession.
1. Buy growing companies with a strong competitive moat
Investors need to remember that investing is a marathon and not a sprint. Great companies need years or even decades to build their business, and the investor who remains vested with such companies will benefit from the "magic" of compounding interest. Companies with a track record of growth and strong competitive moats offer peace of mind to the investor, as recessions and downturns have only a limited effect on their long-term growth.
By buying companies that are the leaders in their fields, such as Starbucks (NASDAQ:SBUX), Apple (NASDAQ:AAPL) and Nike (NYSE:NKE), investors can enjoy a double benefit. Being the leaders in their respective industries, these companies have plans in place to continue to grow and innovate. They also have the resources and balance sheet strength to cope with any protracted downturn.
Apple, for example, has total cash and marketable securities of close to $245 billion, giving the company ample firepower to weather any downturn and also funds available to swoop in to purchase a distressed company it thinks could help it. Apple also has recurring revenue through its various services that is somewhat recession-resistant. Starbucks has a whopping 31,256 stores located around the world and it provides a product (caffeine) and services that many would continue to seek out, even in recessionary times. Nike has nearly $3.6 billion in cash on hand and continues to command a leading market share in the sports footwear and apparel industry. Its recent direct-to-consumer initiatives should help it weather any potential downturns in purchases that might occur at retail partners during a recession.
2. Ensure you have ample cash on hand
The second way to stay prepared as an investor is to always have available cash for deployment into the stock market. As investors will not know when a crash or recession will be coming, it's always useful to keep some cash set aside, rather than putting it all into the stock market. Should stock prices for companies you want to invest in suddenly become much more affordable (for whatever reason), investors will want to ensure they are able to take advantage. This can help average down the cost of their existing positions in a stock or initiate new positions at bargain prices for a stock on a wish list.
There is no universal agreement on the amount of cash to set aside for such potential portfolio injections, but a general rule of thumb is to have around 10% to 20% cash (as a proportion of your total portfolio value) on standby. Investors should also take note: do not eagerly pump all your cash in at the first signs of a potential recession. The average length of a U.S. recession historically has been around 22 months. Take your time to slowly allocate capital as share prices decline, all the while ensuring that the cash does not run out and that you don't need some of that cash for other non-investing reasons.
3. Rely on cash flow from dividends
Some portion of your portfolio should be invested in dividend-yielding stocks. Receiving regular dividends will help ensure you have a constant stream of passive income that adds to your cash stash. Dividend stocks provide a steady stream of (mostly) reliable cash flow for investors on a regular basis.
Though companies may reduce their dividend payments during tough times, very few companies will completely eliminate their dividends unless the business is facing major headwinds. This goes back to the first point about purchasing companies with a growing footprint and a strong moat. These are attributes that enable a company to withstand a downturn and maintain a dividend payout.
Investors may also consider real estate investment trusts (REIT) such as American Tower (NYSE:AMT) or Digital Realty Trust (NYSE:DLR), as these businesses own large portfolios of real estate that generate steady, dependable rental income that the companies are required by law to (mostly) pass through to their investors. Because American Tower locks in property leases for long periods, this provides cash flow stability in good times and bad and that helps the company weather downturns and continue to pay out a dividend. These entities offer an even stronger assurance that dividends will continue to be paid because they work with clients they feel have the financial strength to continue paying for the duration of the lease even in a downturn.
Another category of steady dividend payers is the business development company (BDC). BDCs focus on lending to middle-market companies in defensive industries (i.e., industries that are far less likely to be adversely affected by a recession) and receive steady cash flow from interest charges to such businesses. The BDC then returns that income to investors through an often high-yielding dividend. An example of a BDC is New Mountain Finance Corp. (NYSE:NMFC).
The current dividend yield of New Mountain Finance Corp is close to 10%, and the dividend is paid quarterly. The company has been paying out this level of dividends since at least 2014, while sometimes also throwing in a special dividend of $0.12 per share to boot. Management is adept at selecting less-risky middle-market companies to lend money to, as default risk is the biggest blow to cash flows for BDC. The fact that is can continue to maintain dividends at such consistent levels for so many years speaks volumes about the company's risk management policies.
Do not fear a recession
Recessions are a normal feature of a properly functioning economy, and though they may sound fearful and terrible, investors who have positioned their portfolios well and in accordance with the three points above should not be unduly worried. In fact, recessions may throw up juicy, once-in-a-lifetime opportunities to own great companies at marked-down valuations.