There’s a urban legend in investing that goes something like this: “Stocks keep moving up and to the right forever! Just keep putting money into the market and it will make you rich.”
That may have been true over the past decade, but 2022 has been a very difficult year for investors. Stock prices don’t always keep climbing. The S&P 500 is down almost 17% year to date. It’s been a rough ride.
And who knows what the market is going to do for the remainder of 2022? With the potential for higher interest rates slowing the economy, it doesn’t look good for a positive stock market year.
As investors, what can we do when the entire investing game seems rigged against us this year?
Having the right investment strategy and dodging the punches of course! We may not know how the year is going to end, but we do know where some of the big punches are going to come from!
Profitability Is Going To Decline
The first big swing investors need to dodge is declining profitability. This is the ‘E’ in the S&P 500’s PE ratio.
Profitability will decline for the vast majority of businesses during a recession. Consumers tend to cut back spending, and businesses lay-off workers to try to protect some of that profitability, but the slump in business activity is like trying to hold back a wall of water. It’s almost impossible. Eventually something has to give!
In 2022, we also have the added difficulty of vastly higher interest rates. This is the other big punch to dodge. Higher rates eventually depress earnings at corporations with large debt borrowings, as they will eventually need to renew existing debt maturities. Those higher interest payments mean less money falling to the bottom line for investors. This does not bode well for stock prices in the near future.
What can we do to avoid some of this pain?
First off, avoid stocks that were “High Growth, High PE” investments to begin with. These will likely see the largest declines, as their stock prices were the most inflated by growth prospects. That growth has almost entirely disappeared in recent months, and any earnings are likely to decline as well.
(Arguably the S&P 500 was filled with high-growth tech stocks, and investors may continue to suffer as this new reality crushes investors betting on the S&P500.)
Second, avoid stocks that have high debt levels or upcoming debt maturities that need refinancing at higher rates. This isn’t always obvious, and does require some research… but dodging a punch is always better than taking one in the face!
Value Stocks Tend To Outperform
Believe it or not, value stocks tend to do better in times like these, even though their growth prospects are generally limited. Relative to their current earnings power, value stocks have a lot less distance to fall in order to become ‘bargains’ during a recession.
How do you define “value” stocks? Well, this is a tricky topic. There are many ways to slice the value cake (Low price to book, low PE, low price to free cash flow, etc.), and you can literally find thousands of books on the topic. To keep things simple for this post, I will simply say it all amounts to getting more existing business bang-for-your buck, and less speculation on hypothetical growth.
A quick look at some of the more popular “value” funds shows they’re clearly outperforming the S&P 500 this year.
It’s anyone’s guess if this trend of value outperformance is going to continue in the near future, but value is a strategy that seems to be working in 2022.
The growth crowd may continue hunting for growth during this recession, but it’s only a very rare company that can continue to grow during a recession. These rare unicorns are typically over-priced and probably not worth the extreme cost required to own shares. In other words, “Don’t go chasing unicorns. Stick to the boring old plow horses that we’re used to…”
Stocks That Benefit From Higher Interest Rates
Not every stock falls apart when interest rates rise either. Some actually thrive in high interest rate environments. Credit card companies and banks and are businesses I generally think of when it comes to thriving in high rate environments.
For credit card companies — American Express (AXP), Synchrony Financial (SYF), Discover Financial (DFS), and Capital One Financial (COF) are a few that come to mind. Credit card companies thrive because net interest income (the interest they charge customers minus what they pay for that money) tends to rise during a rising rate environment. On top of that, inflation tends to increase the size of the loans consumers borrow.
Credit card companies aren’t an easy win however — If the recession gets bad enough, consumer borrowing can certainly become depressed, and defaults can rise. Both of which lowering earnings for credit card companies.
Banks are an even trickier proposition than card companies, and I wouldn’t recommend investing in individual banks for beginners. With a bank, good performance during a rising interest rate environment depends entirely upon the loans they’ve made, and what kind of deposits the bank holds. Banks tend to borrow short-term and lend long-term. This can squeeze a bank’s net interest margin if they have the wrong mix of assets and liabilities.
Depending upon the particular mix of loans vs. deposits, they can either thrive or wither. This is why picking bank stocks is tricky. It takes quite a bit of research to understand how this dynamic plays-out.
Hunting For “Recession Resistant” Stocks
Another well-known strategy is owning so-called “recession resistant” stocks. This class of stocks typically provides many of life’s ‘necessities’ at the lowest possible cost.
Food and household goods retailers like Walmart (WMT), Kroger (KR), or Costco (COST) are generally considered low-cost providers. This low-cost provider model helps make the company recession resistant during tough times. People may spend less, but they still have to eat and buy soap. It’s a safe bet that these stocks will do just fine during a recession.
Electric utilities and gas utilities are often pointed at as being “good stocks to own” during a recession due to the ‘necessity’ nature of their products. Stocks like Consolidated Edison (ED), Duke Energy (DUK), and American Electric Power Company(AEP) are all good examples of the steady-Eddy utility stocks (if you buy into this theory). However, I’m NOT a big fan of utility stocks. They tend to be heavily indebted, pay-out huge dividends, retain very little capital for compounding, and act more like bonds than stocks.
In contrast, low-cost auto insurers like Progressive (PGR), and Geico (a subsidiary of BRK-A) are going to do just fine during a recession. Most people still need drive to work (or drive to interviews if laid-off), and are still going to need auto insurance.
You might also consider buying some ‘sin’ stocks. Anheuser-Busch InBev (BUD), Brown-Forman (BF-B), Constellation Brands (STZ), and Altria Group (MO) are a few that come to mind. While technically not ‘necessities’, these stocks are often pointed to as “recession resistant” due to the addictive nature of their products (alcohol and cigarettes). If you don’t have any ethical issues with these businesses, they could be excellent stocks to own during a recession portfolio.
Maybe The Best Strategy: Relax
If there’s one thing I’ve learned about investing in stocks, it’s that gains come in fits and starts. Some years will be real stinkers and other years will be rocket ships. Don’t get too worried about how Mr. Market is valuing your stocks at this exact moment. Mr. Market can be completely manic in the way he values stocks. He can be positive about a stock for years, and then suddenly become completely negative in the blink of an eye. It’ll drive you crazy if you let it.
I’m referring here, to the parable of Mr. Market. The parable teaches investors to use Mr. Market as a tool, not as a way to value investments.
Instead, relax, collect the dividends, and focus on what you own. Good businesses will generate cash, invest in new equipment or buildings, raise dividends, and perhaps even buy-back shares. Ultimately, good businesses will continue to do these things (and grow in value over time), regardless of Mr. Market’s wild mood.
We live in a world that’s (at times) overly focused on market pricing. Which is nuts if you think about it. If you were a business owner would you care what some random person on the street offers for your business? Of course not! Unless his offer was ridiculously good, you’d just ignore him and go about growing the value of your business.
This is what owners of stocks really need to be doing today. Think like an owner, and ignore most of the market noise. As long as you paid a fair price relative to normalized earnings, you’re bound to do OK over the long run.
The biggest trick to building wealth over a lifetime is to always keep compounding… even when the market isn’t going “up”. On the surface this sounds easy, but it becomes much harder to do during market downturns and recessions.
Unfortunately nothing good in life comes in a package labeled “simple and easy”. The compounding the occurs in stocks isn’t like simple compound interest in a bank account. It often happens quietly behind the scenes where the market doesn’t notice.
This is one of the reasons why I’ve always recommended investors track other metrics, instead of tracking market prices. Market prices do not always reflect the true value of a business. I wrote about this in my post Happy As A Clam. It’s well worth a read if you have a few spare minutes.
Even though it might be years until stock prices climb again (potentially even an entire decade), knowing that the true value of your investments is growing behind the scenes will give you the confidence to hold until the day the market swings in a positive direction.
That confidence and patience to wait for Mr. Market is what separates the real investors from the speculators.