During a recession, investors need to act cautiously but remain vigilant in monitoring the market landscape for opportunities to pick up high-quality assets at discounted prices. These are difficult environments, but they also coincide with the best opportunities.
In a recessionary environment, the worst-performing assets are highly leveraged, cyclical, and speculative. Companies that fall into any of these categories can be risky for investors because of the potential they could go bankrupt.
Conversely, investors who want to survive and thrive during a recession will invest in high-quality companies that have strong balance sheets, low debt, good cash flow, and are in industries that historically do well during tough economic times.
- During a recession, most investors should avoid investing in companies that are highly leveraged, cyclical, or speculative, as these companies pose the biggest risk for doing poorly during tough economic times.
- A better recession strategy is to invest in well-managed companies that have low debt, good cash flow, and strong balance sheets.
- Counter-cyclical stocks do well in a recession and experience price appreciation despite the prevailing economic headwinds.
- Some industries are considered more recession-resistant than others, such as utilities, consumer staples, and discount retailers.
Types of Stocks With the Biggest Risk
Knowing which assets to avoid investing in can be just as important to an investor during a recession as knowing which companies make good investments. The companies and assets with the biggest risk during a recession are those that are highly leveraged, cyclical, or speculative.
Highly Leveraged Companies
During a recession, most investors would be wise to avoid highly leveraged companies that have huge debt loads on their balance sheet. These companies often suffer under the burden of higher-than-average interest payments that lead to an unsustainable debt-to-equity (DE) ratio.
While these companies are struggling to make their debt payments, they are also faced with a decrease in revenue brought about by the recession. The likelihood of bankruptcy (or at the very least a precipitous drop in shareholder value) is higher for such companies than those with lower debt loads.
Cyclical stocks are tied to employment and consumer confidence, which are battered in a recession. Cyclical stocks tend to do well during boom times when consumers have more discretionary income to spend on non-essential or luxury items. Examples would be companies that manufacture high-end cars, furniture, or clothing.
When the economy falters, however, consumers typically cut back their spending on these discretionary expenses. They reduce spending on things like travel, restaurants, and home improvements. Because of this, cyclical stocks in these industries tend to suffer, making them less attractive investments for investors during a recession.
Speculative stocks are richly valued based on optimism among the shareholder base. This optimism is tested during recessions and these assets are typically the worst performers in a recession.
Speculative stocks have not yet proven their value and are often seen as "under-the-radar" opportunities by investors looking to get in on the ground floor of the next big investment opportunity. These high-risk stocks often fall the fastest during a recession as investors pull their money from the market and rush toward safe-haven investments that limit their exposure during market turbulence.
Stocks That Do Well During Recessions
While it might be tempting to ride out a recession with no exposure to stocks, investors may find themselves missing out on significant opportunities if they do so. Historically, there are companies that do well during economic downturns. Investors might consider developing a strategy based on counter-cyclical stocks with strong balance sheets in recession-resistant industries.
Counter-cyclical stocks tend to do well during recessions. The stock price for counter-cyclical stocks generally moves in the opposite direction of the prevailing economic trend. During a recession, these stocks increase in value. During an expansion, they decrease.
This group is composed of companies with dividends and massive balance sheets or steady business models. Some examples of these types of companies include utilities, consumer staples, and defense stocks. In anticipation of weakening economic conditions, investors often add exposure to these groups in their portfolios.
Strong Balance Sheets
A good investment strategy during a recession is to look for companies that are maintaining strong balance sheets despite the economic headwinds. By studying a company's financial reports, you can determine if they have low debt, healthy cash flows, and are generating a profit. These are all factors to consider before making an investment.
While it might seem surprising, some industries perform quite well during recessions. Investors looking for an investment strategy during market downturns often add stocks from some of these recession-resistant industries to their portfolio. These outperformers generally include companies in the following industries: consumer staples, grocery stores, discount stores, alcohol manufacturers, cosmetics, and funeral services.
Investing During the Recovery
Once the economy is moving from recession to recovery, investors should adjust their strategies. This environment is marked by low interest rates and rising growth.
The best performers are those highly leveraged, cyclical, and speculative companies that survived the recession. As economic conditions normalize, they are the first to bounce back. Counter-cyclical stocks tend not to do well in this environment. Instead, they encounter selling pressure as investors move into more growth-oriented assets.