An opinion article in Fairfax Media caught my eye this morning. Written by Associate Editor Phillip Baker, it opined that 'The R word looks a reality' on the back of very low business investment in Australia.
It's true that one of the characteristics of a recession is diminished business investment because anticipated returns and/or demand for the thing you're investing in simply isn't there. It's also been over 20 years since Australia had a recession, so we're probably due for another one.
This raises some interesting questions for readers:
What would you do in a recession?
How would you handle it if your portfolio dropped 30 or 40 percent in a few weeks, GFC-style?
Wiser people than me can't agree on whether we're facing a recession, so I won't throw my two cents into that debate. Imagining you're in a recession can be a very useful exercise for evaluating your portfolio however.
It's a real acid test for determining which companies you'd be happy to hold when interest rates fall, consumers lose confidence and become defensive, business investment halts, availability of funding declines, and money generally stops falling from the sky.
So, imagine that we're riding into a recession and the market is about to crash. Here's what you want to have in your portfolio:
- 'Essential' products, and great cashflow
A product that can't be done without, that gets bought day-in and day-out. Healthcare, infrastructure, and grocery stocks Woolworths Limited (ASX: WOW) and Wesfarmers Ltd (ASX: WES) are strong contenders.
Millions of sales every day bolster cashflow and allow reasonable margins, economies of scale and an economic moat. Sales and total transaction value might decline (share prices will get crunched; it's a recession), but Woolies and Wesfarmers should endure very well.
Healthcare is another sector worth considering. Cochlear Limited (ASX: COH) and CSL Limited (ASX: CSL) barely blinked during the GFC, and continue to perform thanks to a strong moat and excellent management. Telecom stocks like M2 Group Ltd (ASX: MTU) or Vocus Communications Limited (ASX: VOC) can also be a solid bet as their bandwidth guarantees customers.
- Loads of cash – and minimal debt
If I knew we were headed into a recession I'd consider taking 50% of my portfolio in cash with me. Since there's no way of knowing for sure, I run the risk of missing out on gains if I always carry that much in cash.
Each investor must decide how much is an appropriate amount of cash based on age, employment and family status, debts, and so on. If you start to suspect a recession could be coming, it's a good time to make sure your cash reserves are up to scratch.
Reducing expensive debt as much as possible is important, but I would keep cash on hand as well – in case of retrenchment or illness, if not for share purchases.
Contributor Owen Raskiewicz has a handy rule of thumb that says carrying 33% cash (and 66% shares) allows you to double your portfolio if the market drops by 50%. i.e. your 66% shares falls to the same value as your 33% cash, and your 33% cash can buy you the same number of shares, effectively doubling your portfolio.
That doesn't mean you have to buy the same stocks, or indeed any stocks during a recession, but it's a useful illustration.
- Look for dividend-paying stocks
Don't necessarily buy them based on % yield at today's prices; that would be foolish (lower case 'F') since earnings might decline even in the most defensive stocks. Buying on percentage of profits paid as dividends is a little shrewder, but still not smart since companies might reasonably be expected to drop dividends in order to boost their finances or build a cash balance.
Just buy defensive companies that pay dividends, because this will help support your income during a recession. Warren Buffett and Berkshire Hathaway might work wonders with retained earnings, but that won't be of any comfort to you if you're struggling for income and/or facing job insecurity.
- Dump the dog stocks
The first thing to go in a recession is access to funds. Dump your dodgy biotechs or mining start-ups that burn other people's money without generating any of their own.
Second thing to go is consumer confidence and consumer spending. Have a very hard think about what kind of discretionary income-exposed retail stocks you want to own. Struggling businesses like OrotonGroup Limited (ASX: ORL) or Myer Holdings Ltd (ASX: MYR) shouldn't even get a look-in.
Third thing to go is lending, which goes down, and bad debts, which go up. All of the banks, Commonwealth Bank of Australia (ASX: CBA), Australia and New Zealand Banking Group (ASX: ANZ), National Australia Bank Ltd. (ASX: NAB), and Westpac Banking Corp (ASX: WBC), can be expected to suffer.
They will generate good income and returns for investors if you pick them up at the bottom, but there's no way I would ride them into a recession or buy them in the early stages.
