Tips for Value Investing During an Economic Downturn

Value Investing During an Economic Downturn

As the economic struggle continues, the COVID-19 cases climb up to almost 2 million worldwide. Some experts say we are already in a recession, while others forecast an economic depression. What do we mean by a recession? Most agree that a recession occurs when the economy shrinks for 2 quarters or 6 months. Hence, it is a little early to say we are in a recession. But, it is safe to say we are in an economic downturn. So, how do you prepare a recession-proof portfolio? Most often, you do so by re-assessing your portfolio and looking at value investing strategies.

In the last post, we went over tips to survive your first stock market crash. Let’s dive into investing in a recession and look at value investing strategy.

Value Investing

During an economic downturn, investing for value is an attractive option for many. Economic meltdowns are painful to your portfolio, but there is a positive side. Many good companies are often sold at very low prices by panic sellers. This makes these companies’ stocks become “value stocks.”

A value investing strategy involves identifying stocks that are undervalued by the market at large. Common characteristics of the stock are high dividend yield, low price-to-earnings (P/E) ratio and/or low price-to-book (P/B) ratio. Hence, these stocks usually trade at a lower price than the company’s performance due to market inefficiencies. Value stocks are some of the high-quality investments in a recession portfolio. They could potentially outperform growth stocks. Jason Laux, vice president of Synergy Group in White Oak, says “when economic growth is down, growth stocks can’t go up. Value stocks capitalize on the down market and find opportunities at sales prices.”

Tips for Value Investing During Economic Downturn

Here are three tips for promising value investing during a recession:

• Look before you leap
• Hedge against the downside.
• Avoid value traps.

Look Before You Leap

A thorough analysis is a must for developing a recession investment strategy. You should look under the hood of prospective stocks to see how the engine is running. This means sticking to your investment process of studying the company. The stock should be evaluated based on the company’s underlying strengths and weaknesses. You could research its business model, management team, cash flow, assets and liabilities, strategies and the demand for its products both in and out of the recession. Past performance might not assure a positive future outcome. Yet, it is vital to research the value stock’s performance in a past recession and see it’s track record. This should give you a baseline reference to compare while investing.

Aside from performance, also consider the stability of dividends paid out by the value stock. A company’s dividend history is a good measure of financial strength. A good sign is if a company has maintained or increased its dividend through previous recessions. If you have any further queries on choosing the right stock, feel free to contact us at advisors@kristal.ai.

Hedge Against the Downside

Value investing strategy could prove profitable, but it’s still important to manage risk in your portfolio. Investors should seek downside protection to minimize risk. One way of doing this is by not overpaying and looking for cash-rich companies with minimal debt. Picking large-cap stocks will also give you an edge. It is difficult to find large-cap value stock companies that can remain solvent during the recession.

Another area of focus is picking the right sector to find these value stocks. Anthony Denier, CEO of Webull says, “many of these companies are found in defensive sectors, such as consumer staples, utilities, and telecoms.” He says these sectors are good for value investing during a recession as they cater to consumers’ essential needs.

Avoid Value Traps

Value traps can be costly for an investor who is looking to profit from the discounted price. It is important not to get caught in a value trap. An instance when a stock appears to be undervalued but isn’t is a classic value trap. This happens when the performance and growth of a company have plateaued. The stock might still exhibit a low P/E ratio, a low P/B ratio or a high-yield dividend. Hence, it is necessary to look beyond stocks that appear cheap. Also, focus on earning consistency and high free cash flow.

One way to tweak your value investing strategy to avoid value traps is by looking at funds. Jason Laux says “Investors should consider category value stocks like value ETF rather than individual value stocks.” Value ETFs inherently decrease your portfolio’s risk by potentially protecting it from market volatility.