Five Ways to Recession-proof Your Portfolio

By Jonathan Burton
Marketwatch.com

The "R" word is being spoken louder.

The chance that the deepening housing downturn will drag the broader U.S. economy into recession is troubling more investors. With so many Americans borrowed to the hilt against their home equity, many investment strategists and economists are viewing the housing slump as the tipping point that sinks consumer spending at a time when U.S. businesses aren't reaching for their checkbooks either.

"With housing starting to show some weakness and energy prices remaining where they are, the risks are building and starting to take a real toll on the consumer," said Jeff Mortimer, chief investment officer for equities at Charles Schwab Investment Management.

Whether in recession or retreat, an economy in decline brings investors new challenges -- and opportunities. Talk of the economy making a "soft landing" or a "hard landing" has important implications for stock prices. But the preparations are for landing, not take-off. Accordingly, decisions that worked in the early and middle stages of the economic expansion now give way to investments more akin to what market pundits call "late cycle" plays.

A well-diversified investment portfolio is better able to withstand whatever blows the economy delivers. Diversification cushions unexpected market risks you can't control. So any portfolio shifts made in expectation of a sluggish economy later this year or next should be moderate, not manic. After all, while the investment horizon looks cloudy, a storm may not strike. You just want to be ready.

In these waning innings of the U.S. economic cycle, fast-growing small-capitalization stocks, high-yield bonds, emerging markets, commodities, metals and other riskier, lower-quality investments are out. Defensive, high-quality, dividend-paying large-cap U.S. and international stocks, short-term bonds, bank certificates of deposit and everyday cash are in.

"There's more concern about the magnitude of any slowdown," said Alec Young, an equity market strategist at Standard & Poor's Inc. "A defensive approach makes more sense."

1. Go Big; Buy Quality

An old investing adage dictates that when earnings growth is abundant, the market prices it like water. When growth is scarce, it's priced like diamonds.

When the economy slows, many companies fall short of the earnings growth that Wall Street expects. The institutional investors and hedge funds that move stock prices tend to have a short-term focus, and they are unforgiving of companies that miss the mark.

In a downturn, negative earnings surprises are more likely to hit smaller firms that are having difficulty finding the financing and customers needed for growth. Companies in cyclical industries such as technology, luxury items and other discretionary consumer goods, real estate, investment banking, commodities and industrial materials are particularly vulnerable.

Markets hate uncertainty, so investors then embrace companies that can deliver predictable growth -- a higher quality of earnings. Such firms tend to be larger, with strong footprints in solid industries and steady streams of cash to run the business and pay dividends. While these stocks can certainly slide in a slowdown, they typically will lose less than their smaller rivals. "Larger-cap companies are going to do better," said Ted Parrish, co-manager of the Henssler Equity Fund (HEQFX).

"They are going to find it easier to finance projects they find to have higher returns," Parrish added. "They are going to find that any borrowing they need to do is going to be at favorable rates. Smaller-cap companies won't; it's going to put more of a strain on their balance sheets."

2. Defense: Consumer Staples

In the final months of a business expansion and during a subsequent contraction, the top performing sectors are those with the most reliable source of profits. The consumer staples sector -- companies involved with manufacturing and selling of food, beverages, tobacco, household products and personal care items -- has historically held up well at such times.

"People are buying these things regardless of economic conditions," said Young, the Standard & Poor's strategist.

Large-cap consumer staples companies also tend to pay meaningful dividends -- and steadily raise them -- enhancing their overall quality and appeal. Dividend income is always welcome, but especially so in choppy markets when you're effectively paid to wait until the turmoil subsides. Some well-regarded, high-dividend payers include tobacco giant Altria Group Inc. (MO) which sports a 4.1% annual yield, paper-products maker Kimberly Clark Corp. (KMB), at 3.1%, and consumer-products titan Procter & Gamble Co. (PG), yielding 2%.

S&P stock analysts strongly recommend Altria and Procter & Gamble shares, along with other consumer companies such as PepsiCo Inc. (PEP), confectioners Hershey Foods Corp. (HSY) and Wm. Wrigley Jr. Co. (WWY), and drugstore chain Walgreen Co. (WAG).

3. Defense: Healthcare

The healthcare sector, and pharmaceutical companies in particular, also tends to produce predictable earnings and revenue in economic declines, making many of these stocks standouts in the defensive crowd. Big pharmaceutical firms also can pay substantial dividends. Shares of Merck & Co. (MRK), for instance, recently yielded 3.7%, while Pfizer Inc. (PFE) paid investors 3.4% and Johnson & Johnson (JNJ) yielded 2.3%.

"Pharma is recovering," Young said. "Pfizer is turning itself around." S&P also likes shares of Johnson & Johnson, Eli-Lilly and Co. (LLY), with a 2.9% yield, and biotechnology leader Genentech Inc. (DNA). "It's the dependability factor," Young said. "People think the earnings are going to be there."

4. Take It to the Bank

"People need to re-embrace the old-fashioned certificate of deposit," said Marilyn Cohen, president of Envision Capital Management Inc., which specializes in bonds and other fixed-income investments.

"CD yields are better in the six- to 12-month range than a bond would be," she added, "and there are no credit quality problems."

Cash is king again. The fat yields on short-term investments such as CDs, money-markets and U.S. Treasury notes pose stiff competition for rate-sensitive bonds and stocks. One-year CDs and six-month Treasury bills both pay around 5% -- and the Treasurys are state income-tax free.

"Keep it simple," Cohen said. "My first line of defense would be to buy six-month CDs and 12-month CDs." U.S. government agency bonds are also yield-rich, Cohen said. She recommends a Federal Home Loan Bank issue maturing in February that yields about 5.25%, and for investors willing to venture out further, Fannie Mae paper maturing in 2011 yielding 5.4% Why take more risk now in longer-term bonds? "Money-markets are real juicy now, but they won't be for long," Cohen said. "Whether we have a hard or soft landing, rates are going down," she added. "Short-term paper will roll over at a lower yield; longer-term rates will eventually yield you more."

5. Leave Home

If the U.S. economy slows, export-driven emerging markets of Asia and Latin America and commodity-based economies such as Australia and Canada could be pressured. Europe and Japan have more diverse economies and a strong consumer base that can support corporate earnings growth even as U.S. demand slips.

"Rotate to Europe to offset a U.S. decline," said S&P's Young, "and steer away from emerging markets." Companies on S&P's recommended list include household-products leader Uniliver (UN) and food giant Nestle S.A. (NSRGY), and big pharmaceutical firms Astrazeneca Plc (AZN) and Novartis A.G. (NVS).

Mortimer, the Schwab strategist, said he would focus on Europe as well as Japan, but cautiously. His recommendations include GlaxoSmithKline Plc (GSK), the U.K.-based drugmaker, which he called "a fairly defensive position that could really pay off in a slowing economy."

Mortimer also likes Toyota Motor Corp. (TM), which recently surpassed Ford Motor Co. as the No. 2 U.S. automaker. "While the [automobile] companies in this country continue to struggle, Toyota is really dominating," he said.

In addition, Mortimer tapped Nestle, the world's biggest food company, largely for its worldwide brand-name recognition and defensive qualities.

"It doesn't matter what country you're in; the same themes play out," he said. "Take risk out of your portfolio." Jonathan Burton is MarketWatch's investments editor, based in San Francisco. Reporters Carla Mozee and Shawn Langlois contributed to this story.

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