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.
Key Takeaways
- 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.
Credit Crunch
The more leveraged a company is the more vulnerable it can be to tightening credit conditions when a recession hits.
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
Cyclical stocks are often 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.
Cyclical Assets
Stocks that move in the same direction as the underlying economy are at risk when the economy turns down.
When the economy falters, however, consumers typically cut back their spending on these discretionary expenses. They reduce spending on things like travel, restaurants, and leisure services. Because of this, cyclical stocks in these industries tend to suffer, making them less attractive investments for investors during a recession.
Speculative Stocks
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.
Speculation
Speculative asset prices are often fueled by the market bubbles that form during an economic boom—and go bust when the bubbles pop.
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.
Strong Balance Sheets
A good investment strategy during a recession is to look for companies that are maintaining strong balance sheets or steady business models despite the economic headwinds. Some examples of these types of companies include utilities, basic consumer goods conglomerates, and defense stocks. In anticipation of weakening economic conditions, investors often add exposure to these groups in their portfolios.
Strong Balance Sheets
These companies are less vulnerable to tightening credit conditions and have an easier time managing the debt they do have.
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.
Recession-Resistant Industries
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.
Counter-cyclical stocks like these tend to do well during recessions because their demand tends to increase when incomes fall or when economic uncertainty prevails. 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.
Consumer Demand
Many of these companies see an increase in demand when consumers cut back on more expensive goods or brands or seek relief and security from fear and uncertainty.
These outperformers generally include companies in the following industries: consumer staples, grocery stores, discount stores, firearm and ammunition makers, 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.
Let the Good Times Roll
Risky, leveraged, speculative investments benefit from the rise in investor sentiment and the easy money conditions that characterize the boom phase of the economy.
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 and benefit from increasing enthusiasm and optimism as the recovery takes hold. Counter-cyclical stocks tend not to do well in this environment. Instead, they encounter selling pressure as investors move into more growth-oriented assets.