We have likely just entered a recession, which is defined as an economic decline lasting multiple quarters. Recessions are typically scary times for individuals, businesses, and the stock market. Yet this is an unusual recession. Since the current recession has been caused by a pandemic, and not an asset bubble bursting, with unprecedented government action to combat the economic fallout, there's considerable debate as to whether this recession will be quick, or if it could evolve into a longer depression.
While younger investors with a long time horizon probably shouldn't do much to their portfolios, older investors in or approaching retirement may wish to guard against that worse-case scenario, especially since the stock market has bounced back so much off its March 23 lows. Heck, even Warren Buffett is selling stocks, not buying them.
If you're worried about a recession and a double-dip in the market yet want to stay invested, here's how to position your portfolio.
Buy recession-resistant stocks, eliminate economically sensitive cyclicals
One textbook strategy that applies to all recessions is to buy the stocks of businesses that will be less affected by an economic decline, and sell the stocks of companies more sensitive to the overall economy. In addition, since this recession is being sparked by a worldwide pandemic, you might also look toward defensive stocks that also play to the stay-at-home economy.
Typical recession-resistant sectors include consumer staples stocks or utilities. Examples of consumer staples companies include Procter & Gamble (NYSE:PG), the largest consumer staples company in the world, which makes everyday household items such as toilet paper, soap, shampoo, and other products people need to buy in both good times and bad. Another recent staples star has been Clorox (NYSE:CLX), which has benefited handsomely from the fact that it sells disinfectant wipes people are using to clean surfaces more than they ever have before.
Utilities deliver basic necessities such as water, electricity, and gas to individual homes and businesses. Often, utilities are safe because they have monopoly or near-monopoly like status over a given area. However, these companies are often regulated by governments, which limits pricing and growth. Still, the prospects of steady cash flows and dividends make them highly appealing in times like these.
One example is Fool favorite NextEra Energy (NYSE:NEE), which operates electric utilities in Florida, a high-growth state thanks to retiring baby boomers. Additionally, NextEra also owns several renewable energy projects, positioning it well for a more sustainable future. Combine that with one of the highest credit ratings among all utilities, and NextEra is a dependable dividend stock for the risk-off investor, especially in a recession.
On the other hand, if you're worried about a prolonged downturn, you should probably avoid economically sensitive stocks. These may include banks, which tend to do well when the economy does well and visa-versa, or consumer discretionary stocks that make big-ticket items such as automobiles.
In a recession, people have more difficulty paying back their loans, and interest rates fall, putting even further pressure on bank lenders' earnings. And in tough times, people also scale back on large purchases such as cars, which means they may hold onto their existing cars more rather than buying new ones.
Banks and autos are examples of cyclical stocks that tend to boom in good times and bust in recessions. In general, you should be wary of investing in cyclicals if you think we're on the brink of another downturn. However, if the economy comes out of the current downturn sooner, these cyclical stocks could have more upside. Still, for those who are predicting or can't afford to weather a deeper, longer-lasting downturn, it's best to avoid cyclical stocks altogether right now.
Buy stocks with good balance sheets, sell stocks with bad balance sheets
In a prolonged economic downturn, a company's balance sheet comes to the forefront. The balance sheet is the financial statement where a company's assets and liabilities are listed side by side, including a company's cash versus its debt load.
Obviously, in an economic downturn, companies that have saved up cash are a lot safer than those that have spent all their cash, either on growth, or in paying out dividends and buybacks to shareholders. In addition, companies with good balance sheets tend to have cash-generative businesses anyway, so good balance sheets are a doubly good place to look and start buying in a downturn.
An example of this would be Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), the parent company of Google. Alphabet's dominant digital advertising segments are great, high-margin growth businesses, which have given the company an incredible $117.2 billion in cash on its current balance sheet, versus just $5 billion in long-term debt.
That cash pile is looking pretty good right now. Even though Alphabet's core digital ad business is taking a big hit from the pullback in advertising, the company is still generating cash, continuing to invest in its new businesses such as cloud, and is even buying back more stock while its share price is down.
On the other hand, if a company has high levels of debt and its revenues suddenly go away, it could find itself in deep trouble. In a bad case, highly indebted stocks go down in a recession and stay down, as the company in question tries to dig its way out of the debt hole it's gotten itself into. Often, it means raising more capital, which dilutes current shareholders. That's what's currently going on with the highly indebted airlines, which now need government bailouts that could come at a big cost. That's seemingly why Warren Buffett exited all his airline stocks last quarter. In the worst case, high debt could lead to bankruptcy, which just happened to 108-year-old retailer J.C. Penney (OTC:JCPN.Q).
Of course, not all businesses with significant debt levels are doomed. For instance, mobile telecom stocks have lots of debt, but mobile phone subscriptions are fairly recurring, high-margin revenue and profit streams. On the other hand, when you have high debt levels combined with a business that is cyclical, or which is taking a big hit from coronavirus such as airlines or brick-and-mortar retailers like J.C. Penney, that's a deadly combination. All things being equal, stick with cash-rich balance sheets.
For upside, lean toward high-growth stocks
Finally, recessions can be a great time to pick up shares of companies with compelling long-term growth stories. Why would I advocate looking at growth stocks in a recession, which tend to trade at higher valuations? A couple reasons.
One, in a recession, interest rates go down, and lower interest rates make future cash flows more attractive relative to cash flows today. That benefits growth stocks that may not have much earnings today, but strong revenue growth, portending better profits in the future. Second, when growth becomes scarce in a recession, companies that can still grow get premium valuations. Third, companies that are able to grow are largely in the midst of big, long-term technology trends that provide more efficient ways of doing business. These innovations are currently getting accelerated by the stay-at-home economy as businesses feel the need to digitize and automate their businesses. Those types of businesses can actually grow stronger for the long-term in a recession.
One great place to look to day are innovative cloud software stocks, many of which have not only held up well in the coronavirus recession, but have actually increased in value in 2020. These include stocks like Twilio (NYSE:TWLO), which provides cloud-based communications services to enterprise clients. With so many businesses losing their ability to physically interface with customers, Twilio has seen a demand surge as companies look to mobile and email messages to inform and keep up with customers. Another high-growth stock is Datadog (NASDAQ:DDOG), which monitors cloud usage and provides valuable analytics to its corporate customers. A third example is Teladoc Health (NYSE:TDOC), which enables people to speak with doctors remotely, rather than having to go into a physical office. Unsurprisingly, it's seeing a boom in usage.
Twilio, Datadog, and Teladoc have all seen big spikes in their share prices recently after recently reporting strong revenue growth, so they may each experience some pullbacks from here. Yet over the long-term, these stocks shoudl continue to do well. If you fear a prolonged downturn, be on the lookout for similar stocks with recurring revenues, strong growth profiles, and products that help companies deal with the recession at hand. While seemingly "expensive," strong revenue growth should provide a floor under these names through the downturn, and upside on the other side.
Three ingredients for a recession-proof portfolio
In closing, a recession-resistant portfolio should have a mix of stable consumer staples and utilities stocks, stocks of companies with cash-rich balance sheets, and young enterprise-focused growth companies that provide new, more efficient ways of doing business. If you construct a portfolio with these three elements and avoid highly indebted, cyclical, or no-growth companies, your portfolio should hold up fine through a prolonged recession.