Managing Your Portfolio During a Recession
First, let’s cover a bit of background. According to the dictionary, a recession is defined as, “a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in the Gross Domestic Product (GDP) for two successive quarters.” In plain English, that means that business drops, on the whole, for six straight months. People stop or reduce spending on dining out, new furniture, cars, jewelry, and other so-called “discretionary” items, while businesses often cut capital expenditures such as new machinery, hiring employees, or moving to larger facilities.
Fortunately, there are general measures you can take to potentially reduce the long-term damage to your net worth during times of economic stress. As is our custom, grab a cup of coffee, browse through this feature, and consider what you can do to protect yourself and your family.
Focus on Consumer Staple Stocks
No matter how bad things get, people are going to figure out how to eat, buy toilet paper, and heat their homes. When money is scarce, items and services such as these, known as “consumer staples” and “energy”, constantly churn out profits for the companies that manufacture and sell them. Corporations like Procter & Gamble, Clorox, and Colgate-Palmolive aren’t likely to sell less toothpaste, shaving cream, laundry detergent, and dish soap unless things get really, really bad. They are bastions of financial strength in times of trouble.
Likewise, “affordable luxuries,” such as William Wrigley, Coca-Cola, PepsiCo, Hershey, and H.J.
Heinz aren’t likely to feel too bad of a squeeze compared to the broader markets because a man or woman is very unlikely to give up his afternoon Coke or switch to an off-brand chocolate bar because he suffered a pay cut or temporary job loss. In fact, products such as Folgers may even do better as people shy away from $4 lattes and cappuccinos yet want to stick to brand names they know and trust.
Some businesses, such as pawn shops and payday lending stores, are probably going to experience sharp increases in profits and business, so it’s even possible to make outsized gains if you have no ethical qualms about owning these sorts of enterprises. That’s a decision that you will have to make for yourself.
Look for Companies with High Sustainable Dividend Yields
Jeremy Siegel, author and respected professor (read Why Boring is Almost Always More Profitable), has shown in his research that dividends can lower the amount of time it takes you to regain losses in an investment. This is because reinvested dividends during crashes and market corrections purchase more cheap shares that will, in the future, generate far higher profits when the market rebounds.
In addition, dividend stocks often cause a stock to fall far less than non-dividend paying equities because they become “yield supported”. Imagine you were watching GPE Consulting Group common stock (a fictional company) at $100 per share. The shares pay a $5 dividend, yielding 5% ($5 cash dividend divided by $100 per share price = 0.05, or 5.00%), while United States Treasuries are paying 4.65%. Future prospects look decent; not terribly exciting, but as good as one can expect.
Now, imagine that there is another company, River Rock Chocolate and Ice Cream (another fictional company) with a $100 per share price and no cash dividend.
Now, picture for a moment the following scenario: The stock market crashes. Investors panic, ordering their 401k plans to dump the equity mutual funds, forcing professional money managers to get rid of stocks they know are cheap. In the beginning, both GPE Consulting Group and River Rock Chocolate and Ice Cream crash to $60 per share. GPE now has a dividend yield of 8.33% while River Rock continues its no-payout policy. If the mutual fund manager has to sell off more shares, which one do you think he’s going to choose? I can almost guarantee that if prospects for the firms are equal, the dividend paying stock makes it to the next round while the non-dividend paying stock gets cut.
International investors, wealthy individuals, and institutions are also likely to notice, at some point, the shares of companies trading at prices where the dividend yield grossly exceeds bond yields. If they believe that the payout is sustainable (the company will continue to make enough profit to pay, or “service” its dividend in industry speak), they are going to be inclined to invest. The end result of this is that portfolios consisting of more cash-generating dividend stocks tend to have far less volatility and suffer gentler falls than their counterparts.
Remarkably, this is true even when the dividend is cut provided that the stock price declines at a greater percentage than the dividend was lowered. Another benefit is that cash dividends signal to the broader market that the profits reported on the income statement are tangible. In times of financial crisis, the fact that one firm can prove it is making money by sending you cash in the mail provides it a lot of favor in investors’ collective eyes.
In times of economic stress, liquidity is king. That's why during a recession, you want a lot of cash, cash equivalents, or access to money in some way at your disposal in the event that you lose your job, the stock market crashes and you don’t want to sell your shares at depressed prices, you suffer a pay cut of some sort, are disabled, or you own a business and sales start to drop.
Many of the best value investors in the world, including Tweedy Browne and Third Avenue, have routinely kept cash on their balance sheet to serve as “dry powder” for when markets fall. Although the greenbacks can serve as a drag on returns when the markets are exploding, they can offer very large benefits when stock prices begin to fall. In the meantime, you’re likely to collect at least a few percentage points of interest or money market dividends, possibly keeping pace with inflation.
Tax-free municipal bonds can be a good choice for the right type of investor. So can Treasury bill, bonds, notes, saving accounts, checking account, and money market funds. Professional investors and institutions might get into some of the more esoteric instruments such as commercial paper or repurchase agreements, but that’s not an area for the inexperienced to tread.
… and Debt Poor
An important part of reducing your risk during a recession is lowering your fixed payments. Debt can be a terrible thing if not handled properly because it introduces payments that include interest, which is really nothing more than the cost of “renting” money. Your goal is simple, and you should never forget it: You need to conduct your affairs so that if you were to lose your job or suffer a sudden, unexpected cash need, you would not be on the brink of disaster. If things get extraordinarily difficult yet you have a reasonable expectation for them to return to normal within a short time, you could even use your expanded borrowing capacity to help temporarily tide you over on items such as groceries.
Typically, low-cost, consolidated student loans and home mortgages are the least worrisome. There are always exceptions – you are probably in real trouble if you make $25,000 per year and have $90,000 in student loans (it’s still possible, so don’t despair!) but because of the tax advantages and relatively low interest rates, you are more likely to get in trouble by having high credit card or car loan balances. Not only are the interest costs potentially enormous depending upon your credit rating, but they aren’t tax deductible, making their true cost relative to other forms of debt substantially more expensive. The good news is that you can find tons of great resources out there to help you pay down your debt in order to strengthen your personal balance sheet.
Maintain Your Asset Balance
Investing is all about rationality. Many of the traditional portfolio models make very little sense for the experienced business leader with extensive accounting knowledge and financial experience. For the average person, who might not really understand what a stock is or why he or she owns shares of an S&P 500 index fund, lowering volatility (the rate and severity of price fluctuations) can be an important goal. That way, they are going to be less likely to dump equities when they are cheap out of fear.
This topic is known as asset allocation and was covered in the special article Introduction to Asset Allocation. In short, the practice is nothing more than moving an investor’s money into different asset classes such as stocks, bonds, mutual funds, real estate, gold, other commodities, international firms, fine art, etc. The theory is based on the idea that not all markets are correlated – that is, when one goes down, and other might remain untouched or even increase. Thus, the investor is less likely to panic, dividends can be reinvested, dollar cost averaging plans followed, and the wealth manager has protected the client from their psychological urge to “conquer” the market by trading trends.
A perfect example are members of my own extended family who, in the aftermath of the September 11th stock market crash, sold the stocks in their 401k plans at dirt cheap prices because they didn’t want to “lose more money.” While that may make sense for a day trader speculating on the short-term direction of lower quality stocks, it doesn’t hold water for long-term investors that are buying blue chip companies, reinvesting their dividends, and continuing to work. They moved into money market funds at a time when rates were lower than they had been in nearly half a century, only to earn anemic returns while Wall Street ultimately recovered and skyrocketed. For this type of investor, a balanced portfolio can reduce your fear because you aren’t going to see a direct correlation with any of the major areas of the financial world.
You always hear people talking about diversifying your assets but hardly ever about your cash generators! The worst thing that can happen to your portfolio during a recession is that you lose your ability to generate income and are forced to sell off assets to cover living expenses. The problem is, you are selling at a time when the securities (stocks, bonds, etc.) you own are likely to be cheap! Who wants to sell their house in a down market? Yet, that is precisely what many people do because they lose a job or the factory is forced to cut their hours, and they have a choice between spending their savings and using credit cards, often at high interest rates. This wouldn’t be necessary were it not for the stark reality that many families do not cut expenses quickly enough when income falls.
In addition to the emergency backup fund, it could be prudent to establish your own, controlled backup cash generator to serve as a source of income for your family. Early in my career, my obsession was with creating these “cash generators” that would bring in investment capital no matter what I did with my day. During college, I’d be sitting in a coffee shop reading annual reports and collecting dividends, royalties, interest, and fees from my past projects and investments while my friends worked at retail stores and restaurants, selling their time for a much smaller paycheck. This approach was key to my success because I didn’t come from a wealthy family and knew that one of the surest ways to build my net worth would be to focus on scalable items – where I could get paid for successive units sold after the work was already done. In other words, I’d rather be the guy that designed a new type of lipstick and sold millions of units rather than mowing lawns because each excess unit of lipstick generates profits but doesn’t require much additional effort yet to make more money in the lawn care business, I’d need to put in more hours and hire more people.
Tens of millions of people now generate excess cash by selling goods on Ebay. Think about that – it would have been almost incomprehensible twenty years ago. If you can find a product people want and are able to sell it at a price with attractive enough margins, you are going to bring more capital in to your life. If you use this to buffer your investments, build up a cash reserve, and pay down your debt, you will find that you don’t rely on your job as much, freeing you from the emotional prison of dependency. Others use their day jobs to fund projects such as car washes, storage units, or opening a gift store. None of these is a sure thing and can actually lose money if you aren’t careful, but provided things go well and management is able, it’s possible to turn a profit.
Consider Investing in Tangible Goods
If a recession happens to be accompanied by the chance of rising inflation – which is not a given – you might want to consider investing in some sort of tangible asset that is likely to be unaffected by a drop in the purchasing power of the dollar. In the current market, investors that have great credit, plenty of cash, and little debt might be able to find absolute steals in real estate, picking up properties for far less than they were selling for only a few years ago. This value-based approach is the heart of the statement often made by Warren Buffett that you should, “be greedy when others are fearful and fearful when others are greedy.”
The only caution is that there is considerable historical evidence that suggests real, after-tax, inflation-adjusted wealth is far more difficult to generate in the commodity and real estate markets as it is by owning businesses and common stocks. Of course, there are always exceptions, but on a buy-and-hold basis, they don’t appear as attractive to me for the average investor that doesn’t have a high level of knowledge about macroeconomics and usage trends of metals versus inventory levels, for example. The theory holds that these types of investments could offset the damage that is done during inflationary times to bonds and other fixed-income investments.
There is little doubt that the 21st century belongs to China and India. The European Union is just now coming into its own in the years following the introduction of the Euro, currency model. One implication for an investor’s portfolio is that there is going to be a lot of wealth creation outside of the borders of the United States of America. As a country, we find ourselves in the same position as Great Britain during the 19th Century when J.P. Morgan’s father was running his banking operations from London and shipping capital over to our nascent republic, investing our infrastructure and corporations with the hope of big profits and anything-goes capitalism.
Although this is certainly going to present some challenges as our society adjusts to the changes, there is money to be made and prosperity to be had by taking advantage of the new global economy. Several of my favorite mutual funds offered by companies such as Third Avenue and Tweedy Browne (full disclosure: my family and I have investments with these firms) already offer private accounts (separately managed accounts) for high net worth individuals and mutual funds for the masses that invest extensively throughout the world.
These are important components in a global portfolio because of the adage that “when the U.S. sneezes, the world catches a cold,” might not be true in the future. For a recession-resistant portfolio, international assets can often be uncorrelated with the financial realities back home, providing a nice buffer. The fundamental rule that Price is Paramount still applies, however. It isn’t enough to buy a good stock, in a good industry, operating from a growing country because if you pay too much, you’re going to lose money. It’s that simple.
Look for Hidden Bull Markets During a Recession
Former hedge fund manager Jim Cramer is famous for saying “there’s always a bull market somewhere.” He’s absolutely right. No matter how bad the economy, no matter how terrible the job market, nor how high the cost of debt, there is always some pocket of the world where it’s incredibly easy to make money because of circumstances that have converged. If you don’t feel as if you possess the necessary skills, experience, temperament, and expertise to find them in the financial markets, you might be better suited to creating them yourself. A recession, after all, just means the overall economy is shrinking – it doesn’t mean you can’t increase your income!
Some companies may experience falling share prices while earnings-per-share go through the roof. Those opportunities don’t come along every day, but when they do, you can be certain that you have a much higher chance of being rewarded handsomely five or ten years down the road. During the least recession, I was picking up shares of stock in a rapidly expanding teen retailer that had fallen to fire sale prices. Today, with dividends reinvested, the value of each share has increased several times over despite the dot-com meltdown, the war on terror, higher national debt, and a declining dollar. Why? A few quarters of recession isn’t likely to make teenagers spend less in the long-run on fashion-forward denim jeans or polo shirts. I mean, if you are a parent, when was the last time your son or daughter walked in the door and said, “I’m not going shopping at [insert company here] due to the recent contracting in Gross Domestic Product”?
Although the media makes a great deal of noise when a country is in, or thought to be approaching, a recession, the fact is that it isn’t the end of the world. If you conduct your affairs conservatively, don’t depend entirely on your day job for your income, and plenty of cash on hand while boasting little or no debt, you’re going to be fine. Likewise, if you run your own business and focus on keeping costs low, margins sufficiently high, and reduce spending in-line, you’re probably going to come out ahead of the game by using these downturns to dollar cost average into your portfolio. In hindsight, many professional portfolio managers were using the recession of 2001 to buy shares in companies that would later increase exponentially.
This advice is hardest to follow for those bogged down with large student loan bills or those trying to raise a family. When overwhelmed with a mortgage payment, car loans, baby formula, and credit card debt, the idea of not relying on a job can be terrifying. Yet, in these circumstances, it’s all the more important that you recession-proof your life, even though it’s going to be far more difficult than for someone who is young, unattached, and highly compensated.
Those who have studied the time value of money know that it can decades to reach true financial independence and statistically, you are likely to encounter many recessions during that time, perhaps even a depression. Just like getting in shape, earning your education, or raising successful children, building your fortune and becoming wealthy is not easy. In fact, at times, it can be downright frustrating, painful, and exasperating. But in the end, it’s worth it if you have done it honestly, ably, and admirably.
Why not to rebalance your portfolio.