3 Stocks That Can Thrive Through Recession

In collaboration with Rida Morwa.

The Fed has finally signaled a pivot on interest rate policy and is expected to begin cutting interest rates in September. The question has changed from whether the Fed will cut interest rates to how far and how fast it will cut them.

In recent decades, the Fed has tended to cut rates very quickly. It is usually faster and steeper than the market expects. Certainly, every investor should consider the possibility that the Fed will cut interest rates substantially over the next year.

If the Fed tapers quickly, it’s likely bad news for the economy. The most obvious reason the Fed would cut rates quickly would be if unemployment continues on its current trend and continues to rise.

So if If the Fed cuts interest rates like it did in 2001 or 2008, chances are the stock market will also suffer because the cuts will be associated with a weakening economy. Investors can generally expect to see a lot of red in their portfolio if this happens. A 30%+ selloff for the indices is certainly on the table.

What flavor will be the next sale?

With a potential recession on the horizon, what should investors do about it? Some may be tempted to sell everything and “sit on the sidelines” with their money. However, this strategy can blow up in your face if a recession doesn’t occur. While I believe a recession is imminent, it is impossible to know the future with certainty. As investors, we need to know the difference between what we have credit and what we i know. The market has a nasty way of humiliating people who confuse the two.

Another alternative is to focus on buying investments that are relatively cheap. The bigger an investment, the more it has to go down. During the “Dot-Com” crisis, it was the dot-com companies that took a nasty hit in their valuations and crashed the most. The companies that were most affected were large-cap growth stocks.

During the Great Financial Crisis, it was the other way around. Large-cap growth stocks sold off as part of the “all-in,” but generally had smaller declines and faster recoveries. Banks, REITs and other financial companies were crushed and fell much more than the S&P 500.

People often ask me what stocks are best to own in a recession, and the answer is “Which recession?”.

Consider ratings

What is relatively expensive today?

Large-cap stocks are trading at a higher price-to-earnings ratio than they have for most of the past 20 years. They are slightly lower than they were in 2001, but much higher than they were going into the GFC: Source

The other major division in stock valuation is Growth vs. Value: Source

This is less definitive, although it is interesting that both growth and value stocks are trading at roughly the same P/Es they were at just before the recession of 2001. Note that growth stocks fell sharply in 2000, while the rest of the market was relatively stable. So before the recession, a strong downtrend was already underway for growth stocks. Today, growth stocks are closer to a top and haven’t been trending down.

We probably won’t see a more than 80% crash in the Nasdaq, valuations aren’t that inflated. However, it’s clear that two characteristics stand out in stocks trading at P/E ratios that are elevated relative to where they’ve been for the past 20 years: large-cap and growth.

On the other hand, small and midcaps are trading at valuations that are below average and very similar to 2001. Value stocks are trading slightly higher than they have been in the past 20 years, but are about the same place as in 2001.

We must remember that we are looking at high-level environments. Many large-cap stocks are growth stocks, but not all. For example, Walmart (WMT) is a Value stock, but also a large-cap one. It trades at a forward PE ratio of 31x. This is certainly at the higher end of its historical valuation range. There are plenty of other examples of larger-cap stocks that would fall into the Value category but are trading at relatively high valuations, even though many other Value stocks are trading at their lowest valuations in decades.

History doesn’t repeat itself, but it sure rhymes

If there is a recession, stocks that are expensive relative to their own histories are likely to fall the most. This has certainly been the case in historical recessions. Today, the companies that are the most expensive tend to be large caps, growth stocks, or both. Companies that are the least expensive are small/mid-cap, value, or both.

This setup is most similar to what we saw in 2001. I filled my portfolio with holdings that are most similar to the ones that did very well through the 2001 recession. Here are some stocks I bought, which absolutely crushed it through the 2001 recession and are trading low today.

Real estate income

Real estate income (O) is a real estate investment trust that uses triple net leases. It became the largest REIT in its category and rewarded investors with frequent dividend increases.

Like many REITs, O had a significant market gap in the late 1990s. Investors were in the red, even as indexes were hitting all-time highs. A scenario that people tell me leads to a lot of frustration.

In late 2000, O began to catch up. In 2001, once the Fed started cutting interest rates in January, O didn’t look back. It advanced while the S&P 500 and other indexes fell.

Investors who had been burned by the decline in growth stocks were drawn to O’s growing dividend, the stability of its business model and its low valuation.

Today, O trades at a higher valuation than it did in 2000. It trades around 15x FFO. However, O is undoubtedly a stronger company and a much lower risk than it was 25 years ago. In recent decades, O has gained scale, efficiency, an A- credit rating and much more acceptance among investors. Remember, in 1999, REITs weren’t even a recognized sector in the S&P. The sector was new and foreign to all but the most savvy investors.

From O, we can expect continued dividend growth averaging 4-5%/year and there is plenty of room for the valuation to climb into the low 20x/FFO price range.

EPR properties

In 2000, EPR Properties (EPR) was a REIT that focused exclusively on movie theaters. Like O, EPR underperformed the S&P 500 in 1999. It fell much more, which is probably because it was a newer REIT at the time.

Also, like O, this changed in early 2001 when the Fed cut rates and the recession began:

Note that during this period, EPR outperformed the S&P 500 and outperformed O. The company that fell more had more upside.

Today, EPR has surpassed peers like O from COVID. With a focus on “experiential” real estate, defined as places where people go to do things, EPR has been hit much harder than most other REITs. At one point, he collected only 20% of the revenue as his properties were targeted more by government shutdown orders. However, EPR sailed through that period without issuing more debt or equity. As a result, EPR has less debt and less common stock outstanding today than it did in January 2020. In short, EPR has not made any capital decisions that permanently affect future earnings.

EPR has over $1 billion in liquidity and plenty of room to grow. With a high cost of capital, EPR management remained patient rather than pushing growth for growth’s sake. As interest rates fall, the EPR has the option to start rising. Conditions that are quite similar to the early 2000s when EPR was a new company looking to grow while interest rates were low.

Annaly Capital

Annaly Capital (NLY) is a REIT that invests in agency MBS. Agency mortgage-backed securities are MBS that are filled with mortgages that are guaranteed by the agencies – Fannie Mae or Freddie Mac. If a borrower defaults, the agency will buy back the mortgage at face value. NLY invests in this asset class on a leveraged basis. As a result, they bear no credit risk, but end up with significant interest rate risk.

NLY has a history of periods of absolutely outstanding performance interspersed with years of mediocre performance. Agency mortgage REITs are the best recession insurance you can buy because the times when agency MBS thrive are the times when market indexes crash.

Since 2001, the NLY has underperformed the S&P 500 since 1998.

When the recession hit in 2001, NLY worked its magic.

While the market was red, NLY was rising, the price more than doubled. At the same time, it increased its dividend by 150%.

NLY invests in an asset class that is considered a “flight to safety” asset. It has no credit risk. As a result, agency MBS do best when bond investors get scared and run to safety. When investors are bold and exposed to risky assets, agency MBS tend to underperform. As a result, NLY is a truly countercyclical investment. It works best when the stock market is a disaster. It tends to underperform when the economy is strong and the stock market is generally bullish.

Conclusion

O and EPR are situational choices. They are able to outperform in some recessions. In particular, O and EPR will struggle during a GFC-style recession where finances are punished and it becomes difficult to borrow money. They will work relatively well in recessions where banks have good liquidity and credit freezes are not a problem.

NLY is a company I will probably keep in my portfolio for the rest of my life. It has the potential to outperform in every downturn, regardless of the cause. The reason is that agency MBS is an asset class where money goes when fear is high.

These three picks together underperformed the S&P 500 in the years leading up to the 2001 recession, but dramatically outperformed during and after the recession:

This superior performance overcame the poor performance of 1998-2000.

More importantly, from an income investor’s perspective, the dividends paid by these investments have grown even without any reinvestment:

If we do see a recession, I think these three picks are well positioned to repeat this outstanding performance. If the Fed somehow manages to create a “soft landing” by buying at relatively low valuations, shareholders are setting themselves up for reasonable total returns and a high level of income.

In theory, stocks that trade at high valuations can continue to go higher. Buying investments that are trading at low valuations does not always lead to immediate gains. Sometimes cheap becomes cheaper and expensive becomes more expensive. However, over the long term, investors who buy stocks that trade at low valuations will do better. Buy Low, Sell High: Start by buying low.