Rethinking about which stocks to put money in is important when planning to invest in the stock market during a recession. Kavan Choksi points out that for investors who are looking for a bargain deal, choosing to invest in value stocks would be a prudent move. While recessions are likely to have a negative impact on the investors, it is also the time when stocks of good companies are sold off at a low price by panicky sellers. As a result, they become ‘value’ stocks.”
Kavan Choksi talks about the right approach to invest in value stocks during a recession
Value stocks can prove to be a profitable aspect of a recession investing strategy, as they can be sold off at higher prices when the economic situation normalizes. However, while following this investment strategy, investors must not forget about managing risk in their portfolio. Investors must put emphasis on seeking downside protection by avoiding overpaying for a dollar of earnings or cash flow, and look for cash-rich companies that have minimal debt. Selecting large-cap stocks can also provide an edge to investors if those companies are financially flexible enough to stay during an economic downturn.
To leverage the best possible investments for a recession, selecting the right sectors to find value is important for investors as well. Value investing during a recession is similar to trying to find hidden gems at a garage sale. Kavan Choksi mentions that value investors basically aim at finding stocks with share prices that are lower than the book value of the relevant company. A lot of such companies can be found in defensive sectors like telecoms, utilities and consumer staples. As these sectors largely cater to the essential needs of the customers, they are invariably the natural choice for value investing during a recession. As the dust settles and the situation relatively normalizes, value stock investors would want to see a low price-to-earnings ratio, solid balance sheet, strong earnings growth, adequate free cash flow, and preferably also a dividend.
While value investing, investors must be careful about steering clear of value traps. A value trap takes place in a situation when a stock appears to be undervalued but it actually turns out not to be. This situation can occur in case a company has all the hallmarks of a value stock, like a high-yield dividend or low price-earnings ratio, but its growth and performance have plateaued. Value traps can be expensive for investors wanting to buy stocks at a discount during a recession, and hence it is important to avoid them. The term “value” can be interpreted in multiple ways. It is better to put emphasis on the high free cash flow and earnings consistency aspect of this investment strategy, rather than just looking for stocks that appear cheap. Investors must not get deceived by a low cost-per-share price. A simple yet effective way to tweak the recession investment strategy to stay away from value traps is by investing in funds rather than individual companies. Investors should consider categories of value stocks instead of individual value stocks. Category value stocks like value mutual funds and value ETFs can inherently reduce portfolio risk, potentially protecting it from market volatility.