When the market's waters turn choppy and dark, unprepared investors who refuse to change course quickly find themselves capsized and underwater. These bear markets can be difficult for novice and professional investors alike, but there are things individual investors can do to mitigate risk and eke out returns nonetheless.
In this article we'll show you which companies to watch and which to avoid in a down market. We'll then explore four tips to help investors find diversity and safety in rough seas.
Stocks to Watch
During trying times retail and institutional investors flock to companies that make or sell simple, easy to understand goods and services. They focus is on basic necessities known as consumer staples: food, clothing and personal hygiene products for example. During market downturns consumer staple companies have fared well historically. After all, people still need to eat, drink and care for themselves.
So-called sinful stocks are also popular during a recession. These include:
- Tobacco companies - Smoking is not a habit that's easy to abandon just because money is tight, and smokers tend to light up in good times and bad. Examples include Altria(NYSE:MO) and Reynolds American (NYSE:RAI).
- Alcohol producers - Brewers tend to do well no matter what the market climate, and some argue that people tend to drink more during difficult times. Examples include Anheuser Busch (NYSE:BUD) and Molson Coors Brewing Company (NYSE:TAP).
- Gambling companies - Gambling isn't going away anytime soon. The major casino operators have gaming properties around the world, meaning they can ride out recession in North America. Examples include Wynn Resorts (Nasdaq:WYNN) and Las Vegas Sands (NYSE:LVS). (To read about other bear-proof stocks, see Guard Your Portfolio With Defensive Stocks and A Prelude To Sinful Investing.)
Sinful and consumer staple companies aren't the only companies that have a good chance of holding up to a recession. Companies with solid balance sheets are also popular. To test for balance sheet strength, look for companies with a lot of tangible assets such as buildings, land, cash, etc. Companies that generate large amounts of cash flow or that have exceptionally high operating margins tend to be the recipients of investment dollars during difficult times, too. The theory is that they can lower prices and still survive.
While there are no hard and fast rules when it comes to valuation metrics, companies that generally trade at a lower multiple of cash flow, cash, book value and earnings in comparison to their peers may provide a safe harbor. (Not sure how to make these ratios work for you? Check out our tutorial on Investment Valuation Ratios.)
Companies To Avoid
Companies that are second- and third-tier players within their industry don't fare as well in a down market because consumers tend to seek out quality. Also, companies that are in a development stage and have no earnings can be crippled when money gets tight. Not surprisingly, if companies with low multiples for cash flow, cash, book value and earnings are good investments, then those with lofty multiples are to be avoided.
A final red flag to watch for is a companies with unusually low margins. Often distributors and companies that are dependent on one type of commodity fall into this category. For example, when fuel prices are high and the economy starts to slow, trucking and shipping companies usually see their earnings drop. (For added insight into margins and margin pressure, see Analyzing Operating Margins and The Bottom Line On Margins.)
Tip No.1 - Diversify
Investors shouldn't place all of their eggs in one basket, and this is especially true during a down market. Overexposure to a single company or industry can quickly destroy a nest egg if that company goes bankrupt. Depending upon the depth of the market troubles, it may also make sense to seek investment opportunities abroad as well. (To get started, see Investing Beyond Your Borders.)
It makes good business sense to spread exposure among several industries and companies. Warren Buffett has been vocal in his belief that appropriate diversification can be found with only a handful of stocks; however, other well-known investors have suggested that 10-20 holdings or even more may be better. It depends upon the situation and the individual involved. For example, buying 30 individual stocks may not be practical for a person with a nest egg of just $5,000.
Investors should also consider bonds and shorter-term vehicles (e.g. money market instruments) and dividend-producing stocks. These investments have the potential to generate an income stream in good times and in bad; and therefore may help offset some of the losses in the equities portion of their portfolio. (For more quick ways to diversify your portfolio, check out Offset Risk Without Investing Abroad and Introduction To Money Market Funds.)
Tip No.2 - Mutual Funds and ETFs offer Diversity in a Can
Mutual funds and exchange-traded funds (ETFs) can help individual investors obtain proper diversification, particularly for those with smaller portfolios. Even with a small investment of a couple of thousand dollars, an investor has the potential to spread their exposure among a variety of industries and in some cases among a number of countries. (For additional information, see How To Use ETFs In Your Portfolio.)
Another option in a downturn is to invest in inverse ETFs. These ETFs go short, betting against major indexes or benchmarks such as the Nasdaq 100. When the major indexes go down, these funds go up, allowing you to profit while the rest of the market suffers. To be clear investors should consider their risk tolerance, tax implications and a number of other variables before making a switch from one type of investment to another. (To learn about these advanced investing strategies, see Inverse ETFs Can Lift A Falling Portfolio and Short Sales For Market Downturns.)
Tip No.3 - Invest Only What You Can Afford To Lose
Investing is important, but so, too, is eating. It's unwise to take short-term funds (i.e. money for the mortgage or groceries) and invest it in stocks. As a general rule, investors should not get involved in equities unless they have an investment horizon of at least five years, but preferably more. They should also not invest money that they cannot afford to lose. Remember bear markets, or even minor corrections can be extremely destructive.
Tip No.4 - Keep Your Fears In Check
There is an old saying on Wall Street: "The Dow climbs a wall of worry." In other words, over time the Dow has continued to rise despite economic woes, terrorism and countless other calamities. Investors should keep this in mind and try to always separate their emotions from the investment decision-making process. Investing should be a long-term endeavor; what seems like a massive global catastrophe one day, stands a good chance of being remembered as nothing more than a blip on radar screen a few years down the road. (Bubbles grow, then burst, then grow again; to learn more, see our tutorial on The Greatest Market Crashes.)
Investing in a bear market or during other times of crisis isn't easy. However, an investor can weather the storm through proper diversification and by investing in solid companies with real, tangible assets. A long-term investment horizon and keeping your emotions separate from your decision making are the keys to staying afloat.