10 Of The Top Stocks To Hold Ahead Of The Odds-On Recession

10 Of The Top Stocks To Hold Ahead Of The Odds-On Recession
Stéphane Renevier, CFA

over 1 year ago4 mins

  • High-quality, defensive businesses should outperform the rest of the market when economic growth slows and financial conditions tighten.

  • Stocks that should outperform have more than just a recession-proof business model: they have high dividends and buybacks, strong balance sheets, stable earnings growth, reasonable valuation, supportive price action, and low volatility.

  • We name 10 stocks that currently score well across all those criteria.

High-quality, defensive businesses should outperform the rest of the market when economic growth slows and financial conditions tighten.

Stocks that should outperform have more than just a recession-proof business model: they have high dividends and buybacks, strong balance sheets, stable earnings growth, reasonable valuation, supportive price action, and low volatility.

We name 10 stocks that currently score well across all those criteria.

Mentioned in story

Economists, indicators, and the tea leaves are all saying the same thing: a recession is more likely than not right now, especially after the Fed went all guns blazing with its interest rate hike on Wednesday. So let’s assume it’s a sure thing, and start preparing your portfolio accordingly: by defining what all the best recession-proof stocks have in common, and choosing the ones that fit the bill.

Which do recession-proof stocks have in common?

A recession-proof business model

The first thing you want to see is that the demand for a company’s products and services will remain resilient if the economy goes into a recession. Think: a company selling discounted everyday items, or a solar company operating somewhere with ambitious renewable targets.

When looking for recession-proof businesses, the following industries are a good starting point: utilities (people still need heat and electricity in a recession), consumer staples (people still need to eat, drink, and brush their teeth), and healthcare (people still need their drugs). But you don’t have to confine yourself to these industries: you can find hidden gems even in cyclical industries, like the steadily growing pizza chain Domino’s. Similarly, not all utilities, staples, and healthcare companies have recession-proof business modes – WalMart doesn’t sell just staples, for example, so its margins could still take a hit in a recession. That’s why it’s important to do your homework and look at all the criteria for recession-proof stocks.

High and stable dividends and buybacks

As we explained in a deep-dive, high-dividend stocks tend to outperform the broader market when interest rates are rising, when inflation is high, and when economic growth slows. As for buybacks, they indicate that the management not only believes the stock price is cheap, but also that it will help support prices by reducing the amount of shares available –  and hence increase the earnings-per-share.

Strong balance sheets

When everything goes south, the last thing you want is for the company you invest in to have high operational leverage (because a small dip in revenues can cause a big hit to profits), or high financial leverage (because of the risk that it won’t be able to repay the debt). So it’s important to look for a strong balance sheet.

A good tool to estimate the probability of a firm going bust is the Altman Z-score, which uses five key financial ratios. A measure above 3 indicates that the company is safe, while anything below 1.8 indicates possible trouble ahead.

Stable earnings growth

You want to invest in companies that are growing – and growing steadily, and independently of the economy. So, take a look at each company’s profits growth over time. How consistent is it? Does it tend to dip when the economy’s not faring well? Avoid companies that tend to experience large dips, and favor the ones that show consistent, stable growth over multiple years. And make sure the consensus earnings forecasts for the next two years are strong, or at least not far below the market’s average.

Low volatility and beta

The lower the volatility of a stock, the less it’s likely to fall if markets tank. Of course, given we’re in a unique environment, looking at a stock’s history may not be enough, so make sure you also check its implied volatility (which you can do here). It will show you what investors expect future volatility to be. Ideally, you want to see both low historical and implied volatility.

Looking at a share’s beta can help you estimate how sensitive it is to changes in the broader market. A beta of 0.5 suggests that if the stock market loses 10%, your share would drop about 5%. The measure’s not perfect, but it provides a quick way to estimate how defensive a stock is. It can also be useful to identify potentially defensive companies. For instance, here’s a screen of the lowest-beta companies.

A reasonable valuation

Valuation is useful because it measures the “margin of safety” of a company. Rather than just looking at whether a stock trades at a premium or a discount to the market, you should look at how it trades versus its own history. Robust, defensive businesses tend to trade at a premium to the market in all conditions, but may trade below their long-term average when stocks are struggling.

Certain price action

You want to see outperformance in past crises, but you also want to understand the stock’s recent price action. There are two particular patterns that could lead to a good entry point: either the stock has slipped for reasons you think will reverse, or it’s shown strength in the current selloff.

Which stocks make the cut?

Marlboro maker Altria (ticker: MO), personal products darling Colgate-Palmolive (CL), and Coca-Cola’s nemesis PepsiCo (PEP) are three consumer staples stocks scoring strongly on most measures. And in consumer discretionary stocks, two currently screen attractive based on our criteria: auto-parts retailer O'Reilly Automotive (ORLY) and pizza maker Domino’s Pizza (DPZ).

In other sectors, regulated electric utility company Xcel energy (XEL), healthcare stocks Cardinal Health (CAH) and Quest Diagnostics (DGX), railroad operator Union Pacific (UNP), and electrical manufacturer Hubbell Incorporated (HUBB) are also looking pretty attractive based on the attributes we were looking for.

Finimize

BECOME A SMARTER INVESTOR

All the daily investing news and insights you need in one subscription.

Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

/3 Your free quarterly content is about to expire. Uncover the biggest trends and opportunities. Subscribe now for 50%. Cancel anytime.

Finimize
© Finimize Ltd. 2023. 10328011. 280 Bishopsgate, London, EC2M 4AG