If you could opt out of the next economic downturn that hits, certainly you would, right? It turns out you can't, but your portfolio can.
Some lines of business are far more reliable than others. Las Vegas found out the hard way that people don't gamble nearly as much during a recession. But grocery stores and hospitals didn't suffer in the same way -- people continue to eat and need medical attention, no matter the economic climate. Recessions can even be a boon to certain industries, like real-estate sectors that can scoop up property at discounted prices.
When you want to protect your nest egg, while still exposing it to the long-term wealth creator that is the stock market, investing in "recession-proof" stocks might be just your cup of tea. While grocery stores and hospitals might not be the most exciting investments with high growth rates, they'll help you sleep soundly if tough economic times hit.
We'll get into the details of what a recession is and what you should (and shouldn't) expect from recession-proof stocks below. But first, here's a quick look at the five recession-proof stocks we'll be discussing, what they do, and why they're safe in trying economic times.
|Company||What It Does||Why It's Recession-Proof|
|Walmart||Mega-retailer||Lowest prices and growing e-commerce presence|
|Altria||Cigarette maker||People smoke more -- not less -- when stressed|
|Johnson & Johnson||Medical conglomerate||People get sick and need help no matter the economic climate|
|Waste Management||Garbage & recycling||While garbage volume might decrease, it doesn't disappear|
|Grand Canyon Education||Services to higher education||Helps colleges lower tuition -- and enrollment historically grows in recessions|
What is a recession?
The National Bureau of Economic Research (NBER) defines a recession as "a period of falling economic activity spread across the economy, lasting more than a few months."
That's a mouthful, so we'll make it even simpler: It's when people are buying and selling fewer goods and services, and that trend continues for at least half of one year. Generally speaking, economists have come to look for two consecutive quarters (or six months in a row) of shrinking gross domestic product (GDP) as indicating a recession.
The most recent example is the Great Recession of 2008 and 2009. GDP contracted from $14.8 trillion to $14.3 trillion in just one year -- a dip of 3.25%. That might sound small, but spread out across the entire country, the effects were enormous.
Complicated and imprudent bets on the housing market -- among a host of other things -- brought lending to a stand-still. That meant home-builders couldn't get money from banks to start their projects. It also meant start-ups struggled to get the cash they needed to grow. When that happens, the employees of those companies don't get paid. Those employees, then, don't spend money on that new pair of shoes or dinner out with the family, and the effects thus cascade across society. Unemployment hit 10% by late 2009.
Since the end of World War II, the NBER has recorded 11 different recessions. In the last 30 years, we have only experienced three: the Great Recession, the dot-com bubble burst in 2001, and a brief downturn in 1990 and 1991 associated with a shock in oil prices.
Of course, recessions don't last forever. Eventually, we get sick and tired of being sick and tired about the economy, and we move onward and upward. As you can see from this chart, the long-term trends are clear: GDP has continued marching forward -- with each recessions looking like a tiny blip.
Still, in the moment, it can seem like the economic world is ending. Recovery takes time. And in the interim, the stocks of companies that do business in the real world can suffer.
What does recession-proof mean?
This is why people are interested in recession-proof stocks. Almost no company will be completely spared from a recession, but some suffer far less than others. A select few even benefit during the downturn. In general, recession-proof stocks fall into one of two categories:
- They provide a good or service that is vital to the normal functioning of human life. This includes consumer staples like food and basic hygiene, medical products, trash removal, and the utility companies that help keep the heat on during the winter.
- They offer significantly reduced prices on good-enough, non-essential items -- or something people are addicted to. The products these companies offer aren't "essential" to staying alive. But the prices are normally low enough to provide something that helps people feel better about their economic circumstances, but at a lower cost than anyone else can offer. This includes discount retailers as well as "sin stocks" like alcohol and tobacco companies.
All five of the recession-proof companies we listed above fit these categories. Johnson & Johnson and Waste Management provide vital services. People need Band-Aids no matter the economy, and we all suffer if the trash isn't picked up. Walmart offers the cheapest prices around, and the use of Altria's cigarettes -- namely Marlboro -- becomes more widespread when people are stressed.
Grand Canyon might not seem like it fits into either category, but it belongs to the latter. The company's structure is complicated, but essentially, it benefits when more people go to college -- which is exactly what happened in the last recession -- and the company helps bring down the costs of college across the board. Those reduced prices make its services even more enticing during a recession.
Not all recession-proof companies have recession-proof stocks
Here's where things get a little funny: Not every recession-proof company has a recession-proof stock. We measure whether or not a company is "recession-proof" by looking at how its sales and profit were affected during a recession. We look at the actual money changing hands.
However, if you're reading this article, you probably want a recession-proof stock as well. That means finding a stock that doesn't suffer during a downturn. A company's sales are affected by the business it's doing, but its stock price is determined by investor sentiment. Over the short run, the sales the company does only make up a small part of that sentiment. Fear, greed, and a host of other impulses affect a stock's price.
No company is a better example of this than Amazon. From October 2007 to November 2008, sales at Amazon increased 22%. Even though we entered a recession, people were flocking to the company. Earnings also jumped 19%. By all accounts, Amazon as a business was recession-proof. And yet, the stock price cratered -- dropping 65%.
How could that happen? A stock's price is determined by two basic things: how the company has performed (let's say we measure this by earnings per share, or EPS) and expectations for the future (we'll measure this by the price-to-earnings ratio, or P/E). In other words:
(EPS) * (P/E) = stock price
The former reflects the cold, hard reality of the business. The latter reflects the often-fickle emotions of investors. When sky-high expectations are reflected in a stock's price, it will suffer during a recession. It really doesn't matter if the company is growing or not. When investors get scared -- as they always do during a recession -- stocks with astronomical expectations will suffer unduly.
That's why all five of the stocks I've selected have modest -- at best -- expectations baked into their respective stock prices.
Just as importantly, during the three years beginning at the onset of the last recession, all five of these companies had stocks with positive returns that outperformed the market. From December 2007 to December 2010 -- a time frame I'll reference many times below -- the S&P 500 returned negative 11% for investors. But these five companies averaged a 24% return -- including dividends.
Why would someone want to invest in recession-proof stocks?
There's an important caveat about investing in recession-proof stocks: They probably won't have the highest returns. It's true that investing in recession-proof stocks can limit your downside (the amount of money you might lose), but it also limits your upside (the amount of money you might gain). As Motley Fool Co-founder David Gardner likes to say:
"Stocks always go down faster than they go up, but they always go up more than they go down." -- Me-- David Gardner (@DavidGFool) February 5, 2018
In other words, while recessions can have a scary effect on the prices of your stocks, they don't last forever. And because your gains on stocks are unlimited (you could gain 1,000%), but your losses are capped (you can only lose 100%), the long-term trends are decidedly in your favor.
That's why smaller growth stocks -- which normally have higher P/Es and aren't necessarily recession-proof -- tend to outperform all stocks combined, including the "recession-proof" ones.
Here's a look at a comparison over the last 10 years of a basket of small growth stocks (orange line) and the 500 largest companies in the United States (blue line).
By investing in recession-proof stocks, you are trading the possibility for higher returns for the safety of limited losses.
Who should invest in recession-proof stocks?
There are two groups that benefit from this approach.
The first are those who cannot emotionally tolerate the reality of major drops in stock prices. This can include investors of all ages and stripes, and it largely depends on your own appetite for risk. One of the great benefits of investing is that it forces you to be honest with yourself. If the thought of your nest egg dropping 40% in one year would make you lose sleep, recession-proof stocks might be for you.
Not only would you be ill-suited to deal with the emotional stress of a downturn -- it could have a terrible effect on your returns. Often times, selling your investments can be the only way to soothe these nerves. You can't lose any more once you sell -- or so you think. In reality, you have "locked in" your losses by selling at market lows, and you'll be unable to enjoy any upswing that follows.
The second group includes those who cannot financially tolerate large drops in stock prices. This tends to be a more distinct group mostly comprised of those nearing or in retirement. While no money that you need in the next three years should be in stocks, it's still prudent for those in their golden years to focus on recession-proof stocks.
Hopefully, you already have the nest egg you need by age 65. Once you do, you'd want to focus more on maintaining and slowly replacing your withdrawals than growing your nest egg.
Having cleared up all of these details, let's focus on why these five companies are great recession-proof options for your own portfolio.
Because of the company's scale, it can negotiate the lowest possible prices from suppliers and pass those low prices on to customers. During a recession, that can be a huge boon: People know they likely won't find prices lower than what they'll get at Walmart.
During the last recession, that's how things played out. In the three years starting in the fourth quarter of 2007, sales at Walmart jumped 11%, and the stock returned 21% -- including its dividend.
To give you a better idea of Walmart's size and scope, here are a few vital statistics.
|$8.8 billion||$30.2 billion||$18.4 billion||16*||2.1%||33%|
While some might be worried about such a heavy debt load, Walmart's free cash flow shows just how strong the company is. If it wanted to, it could retire most of that debt in short order. But there are better uses for that money -- like paying out a modest dividend and growing it over time. With only one-third of free cash flow being used on the dividend, there's lots of room for it to grow in the future.
Just as importantly, there aren't ridiculously sky-high expectations baked into Walmart's stock price. With a price to free-cash-flow ratio of just 16, investors are expecting moderate growth from Walmart. That makes sense, given the company's size. But I think investments in e-commerce and a stake in Flipkart -- India's leading e-commerce player -- give investors reason to be excited about Walmart whether or not there's a recession in the future.
In 2009, the National Institutes of Health (NIH) put a paper out on smoking behaviors during recessions. The authors found that:
Smokers not only continued to smoke but also actually increased their cigarette intake during this period [Great Recession] of economic difficulty.
While the habit of smoking itself isn't very healthy, holding shares of this industry's largest domestic player -- Altria (NYSE:MO) -- might be. Altria is the parent company to the uber-popular Marlboro brand as well as several discount brands.
It's difficult to decipher how the company's sales fared during the Great Recession since it split its international and domestic operations by spinning out Philip Morris International and its stake in other businesses at the same time. However, the company's stock returned 28% from December 2007 to December 2010 -- far outpacing the broader market.
Here's a rundown of the vital stats for the company.
|$20 billion||$11.9 billion||$7.1 billion||8||7.2%||72%|
There's little doubt about the overall trends in the United States: Fewer people are smoking. For society, that's probably a good thing -- and that trend is reflected in the fact that Altria's P/E is a very low 8. But it hasn't really put a damper on Altria's results because the company has been able to bump up prices just as quickly as people quit smoking, leading to superior results.
Because there are minimal capital expenditures, the power of Marlboro's brand is paramount: Altria spends the same amount of money making the cigarettes, but it has shown an ability to continually raise prices while not losing customers because of it. And yet, only 72% of the company's free cash flow is used to pay its huge 7.2% dividend yield.
If the next recession were to hit tomorrow, you can be sure that smoking rates would rise, and Altria would be one of the top beneficiaries.
3. Johnson & Johnson
You probably use products from Johnson & Johnson (NYSE:JNJ) every day without realizing. Band-Aids, Listerine, Neosporin, Neurtrogena, and Tylenol are all owned by the company. But Johnson & Johnson is a conglomerate, with a medical device division and a pharmaceutical division.
Through the first nine months of 2018:
- Pharmaceuticals accounted for 50% of sales, led by Remicade (arthritis), Stelara (arthritis), and Zytiga (prostate cancer).
- Medical devices accounted for 33% of sales, thanks largely to the company's advanced surgical and orthopedic devices.
- Consumer products made up the other 17% of sales.
Put together, this robust juggernaut should fare well in the face of a recession. During the three-year time frame of the Great Recession, sales increased 2%, earnings jumped 8%, and the stock didn't lose any ground, gaining 1%.
Here's where the company stands today:
|$20 billion||$29 billion||$18.5 billion||23||2.8%||51%|
It's important to note that Johnson & Johnson's three segments complement each other. The consumer segment is relatively stable -- though a recent controversy surrounding asbestos may hamper that. Even if that's the case, though, the pharmaceutical division has been very strong. And if that segment falters when drugs lose patent protection, the medical devices segment can provide a boost.
While its P/E of 23 is a bit high for a recession-proof stock, its 2.8% dividend yield provides some safety. Only half of its free cash flow is used on the dividend, meaning the payout is safe and has room for growth.
4. Waste Management
No matter what happens, the trash needs to be taken out. If it isn't, it piles up in houses, neighborhoods, and streets. Nothing is a stronger motivator than the foul smells and presence of garbage to get us regularly using garbage services.
While the volume of our garbage may subside during a recession because we purchase less, our need for that garbage to be disposed of will never disappear. That's what makes America's largest garbage and recycling specialist -- Waste Management (NYSE:WM) -- so appealing.
The company's size and scope give it huge advantages. At the end of 2017, Waste Management operated 249 landfills, 305 transfer stations to compact trash, and 90 material recovery facilities where recycling took place. Not only does this scale allow the company to spread out costs, but it also helps it learn more about best practices, and then put them to use across its network.
It can offer up cheaper prices to businesses and municipalities with superior service. That value proposition played out during the Great Recession: Sales and earnings actually fell, but only by 7% and 9%, respectively. The reason was simple: There was less trash to collect. At the same time, though, because expectations were so low for the stock (as they are now), it actually returned 13%.
Here's a bird's-eye view of Waste Management today:
|$0.5 billion||$9.6 billion||$1.7 billion||14||2%||46%|
No one likes a negative net cash position -- and Waste Management surely carries a lot of debt. But there are two mitigating factors: The first is that there are enormous infrastructure costs associated with operating all of those landfills, transfer stations, and recycling centers.
The second is the long-term nature of contracts with municipalities. The company's dominant market position means that cash flows are relatively easy to predict. The company is comfortable taking on low-interest debt when it has a good idea of the return it will get on its investments. With a modest dividend that takes up less than half of free cash flow to pay out, the dividend is safe and has room for growth.
5. Grand Canyon Education
Finally, we have what is admittedly a stock that doesn't necessarily fit the "recession-proof" mold. Grand Canyon University was founded in 1949 as a traditional, four-year, non-profit Christian college. When the school ran into financial difficulties in 2004, it opened its doors to investors by becoming a for-profit institution. Thus, Grand Canyon Education (NASDAQ:LOPE) debuted on the public market in 2008.
While for-profit educators have a pretty terrible reputation, Grand Canyon is different. It has a robust on-campus student population that is nearing 20,000, with another 70,000 attending online. Measured by cohort default rates, student outcomes are far better than those of the industry's most notorious players.
Over the past year, Grand Canyon University (GCU) has actually regained its not-for-profit status, and shareholders of Grand Canyon Education (GCE) have been left with a company that provides software and services to GCU in return for 60% of tuition.
Just as importantly, GCE no longer has to worry about on-campus infrastructure costs or staff salaries. Instead it is focused on a number of services, including curriculum development, faculty services, admissions, financial aid, counseling, technology platforms, and -- critically -- online program management.
Admissions to for-profit schools boomed during the Great Recession, which ended up being disastrous, as many schools broke the law by recruiting students with misleading information -- and many students dropped out with a ton of debt and no diploma. But Grand Canyon was not a major offender, and the stock actually hasn't been publicly traded long enough for it to be clear how it might behave during a recessionary period. After all, its IPO occurred in the midst of the 2008 market meltdown. However, the stock did increase 10-fold in its first decade on the public markets.
Here's what the company's balance sheet and valuation look like right now.
|$114 million||$55 million||($9 million)||21||-||-|
The thesis here is simple. Because Grand Canyon was a principled for-profit, it reinvested most of its revenue into developing systems that would make the school more efficient in the long run. That includes software that helps a small group of employees manage tons of paperwork for admissions, financial aid, and the like. Then, it passed on those savings to its on-campus students -- who haven't seen a tuition increase in over a decade.
GCE now has the possibility of offering those software solutions -- and its expertise at building online learning experiences -- to other schools. This includes both for-profit and traditional not-for-profit colleges and universities.
We already know that during the last recession, millennials went back to school en masse. We also know that the price of college is becoming onerous for many American families. That's doubly true during a recession.
Grand Canyon sits at the intersection of these two forces, poised to benefit from bumps in enrollment as well as from being the creator of software systems that could help schools lower their tuition while not going broke. That's a good place to be sitting if a recession approaches.
A final word about recession-proof stocks
I don't like writing too much about stocks I don't own. I want my own skin in the game: If my suggestions are poor, I want to suffer just as much as the readers who may have taken my advice.
That said, I've been investing for over a decade and haven't had a problem (yet!) keeping my emotions in check. Being in my 30s, I'm decades away from retirement, so I don't need to think about "recession-proof" stocks yet. That's why I don't actually own any of these stocks, and I've only given Grand Canyon and Walmart outperform ratings on my CAPS profile. Then again, CAPS is about picking stocks that will beat the market over the long run. Recession-proof stocks are about insulating the investor from wild downward swings in a recession. Those are two very different things.
The bottom line is this: If my retirement were around the corner, these five stocks would be at the top of my list. Conduct your own due diligence before buying shares of any of these companies, and remember the themes -- picking companies that don't have expensive valuations and are in industries with consistent demand -- when selecting recession-proof stocks for your own portfolio.