Recession-Proof Stocks

As noted by James in the previous post, an excellent way to eliminate risk is to go long or short on stock index futures. However, if you don't feel comfortable doing this, or you just enjoy the thrill of picking stocks, there is another way to position your portfolio for an economic downturn.
There is an easy and intuitive way to pick companies and stocks that will generally outperform the market in economic downturns. You can generally pick these companies and stocks out fairly easily.

First off, they will have a low beta (less than one, often much less). Beta is a measure of risk, and in a CAPM world, it is the only measure of risk that matters, as all unsystematic risk can be diversified away. So, low beta stocks are not as correlated with the market as higher beta stocks. This is good in bad times - the market goes down, the stock is neutral or goes up. Say we have a stock with a beta of .5. If the market goes down 10%, this stock will only go down 5% (as the market beta is 1.0). Conversely, if the market goes up 10%, this stock will only go up 5%.

Well, which stocks have a low beta? Companies that are non-cyclical, and provide essential goods that people will buy no matter what the economic outlook. For instance, take Altria (MO). Altria, parent of Philip Morris, makes cigarettes. No matter what the outlook, people are going to smoke and buy cigarettes (they may even buy more due to the stress of the poor economy re: lost jobs and plunging equity markets). So, in a recession, Altria is probably a good pick.

So when picking out a stock to invest in during periods of economic turbulence, think about the business model, and how inelastic the demand of the product the company is. Church and Dwight's (CHD) product (baking soda and Trojan condoms) are almost always in demand - no need to explain why. Their beta is .13. Is CHD going to make you rich overnight, absolutely not, but it provides protection in periods of economic downturn, which is always a good thing.

Of course, not all low beta stocks will outperform the market when the market sours. You of course still have to look at the actual company, it's performance, it's expected performance, and the industry in which it operates. You cannot ignore the stock-specific or sector-specific information as well. One clear example right now would be food-processing companies like General Mills (GIS) or Kellogg (K). These stocks have low betas (.25 and .53, respectively); however, they haven't been burning up the market recently. Why? Well, you have to pay attention to macro factors as well, such as the rising cost of commodities. A bushel of wheat now costs $10 - an all-time high. As input costs continue to rise, investors have become wary about these stocks and their ability to continue to pass on cost increases to consumers. So, in summary, low-beta stocks are generally a good play during recessions or bear markets, but don't become over-exuberant and jump in without considering all the pertinent information related to the stock.