The best defense is diversification.
- Set a % limit for a stock’s total position in your portfolio. For example, no stock can be more than 10% of your total portfolio. The reason is simple – the greater the percentage, the greater the gain or loss you will have. If you wish to limit downside, you must limit your exposure to a single stock. Think about stocks like General Electric, Maxar Technologies, Blackberry – once highly valued and strong enterprises reduced to rubble. Timed right, you would have made a killling. Timed poorly and you would be severely punsihed.
- Choose stocks in different sectors, as some will underperform while others outperform (Oil in Canada has been in decline since 2014). Certain sectors are cyclical, which means they do well when the economy does well and poorly when it doesn’t (for example: manufacturing, construction, consumer discretionary). You can read more about cyclical stocks here: https://www.investopedia.com/articles/00/082800.asp
- You can also diversify by choosing different investment vehicles: stocks, bonds, high-interest savings accounts. This depends on your risk tolerance and where you see the market moving. Late cycle? Saving capital? Consider a balanced portolio – mix of stocks and bonds.
- Stocks that do well in recessions provide a service people must pay for regardless of how the economy is performing. Utilities keep the lights on and water running; grocery stores and discount retailers provide food and goods we use every day, called consumer staples; companies that provide essential services like waste management also fare well. Remember, in recessions most companies still take a hit – there is no foolproof strategy. You must research the business: balance sheet, debt, growth, and security of assets.
A few tips to keep in mind:
1. Look for reliable dividends.
There is debate over whether dividends actually matter in the long run, or whether they truly protect you in a down turn. The rationale for investing in reliable dividend paying stocks late in the cycle is simple: even while the stock is down you’re still getting paid. A recession typically lasts for a few years. In a downturn with no dividend support, you’re sitting negative with nothing to show for it. Dividends at least provide some reprieve from the slaughter. Again, no dividend is ever safe, but best bets are Tier 1, blue chip stocks.
2. Large cap over small cap stocks.
The rationale here is simple too: large cap stocks, also known as market leaders, are unlikely to go bust during a downturn. Consider bread and butter companies that everyone pays a bill to even if the economy collapses: utilities, banks, energy, telecoms. These will still take a hit, but will outlast the dying paper company you decided was strong bet.
3. Low debt and relative strength.
Think back to 2008 (if you’re old enough or know enough; seriously, just watch The Big Short). Beyond pure financial manipulation and terribly irresponsible policy, the average person was swimming in household debt beyond their means. Without enough income to keep the lights on and put food on the table, foreclosures reigned supreme. Similarly, companies with high debt are pause for concern. Some companies utilize debt safely (like many utilities do), but many do not (think of Maxar taking on debt to make acquisitions, and those failing to pan out). The best advice is consider companies with a strong balance sheet. Benjamin Graham suggests a 2:1 ratio of total assets to total liabilities. You should also consider the debt to capital ratio, short and long term debt obligations, and the company’s ability to liquidate quickly if need be. Lastly, with all that said, is the company in a dying industry, growing industry, or essential service? I like using FASTGraphs for this info, and you will see me posting these figures as part of my research.