An increasing number of investors lately claim that a major top has formed in the S&P. Even Warren Buffett recently admitted that he currently has a hard time finding stocks at attractive valuations. Moreover, even if investors ignore these statements, many dark clouds have recently accumulated over the market, signaling at least a remarkable correction, just like the one experienced 2 years ago. More specifically, the government shutdown, the imminent fiscal cliff and particularly the imminent tapering in the Fed's purchases constitute a negative mix, at least for the short-term path of the market.
Therefore, most investors are looking for ways to protect their portfolio. However, the vast majority does not want to sell their stocks because everyone who has attempted to sell temporarily his/her stocks with the intention of buying them back later has been surprisingly left out of the breathless rally of the last 4.5 years. Nevertheless, the investors who want to remain invested should pick up the appropriate stocks, which will perform best in a recession or a pronounced market correction.
For starters, to be defensive, one should select cheap stocks, i.e., stocks with a low P/E. However, these stocks should not be cyclical. As the legendary investor Peter Lynch has said, the fastest way to lose 50% of the capital is to purchase shares of cyclical stocks at a low P/E near a market top. Most cyclical stocks trade at a low P/E when the market trades around the top so great attention is required in the selection of stocks, otherwise the result will be devastating.
Another significant criterion is the performance of a stock in the Great Recession of 2009. If the stock did not decline pronouncedly, it provides an extra safety cushion to the investor. Moreover, the company should not be loaded with debt. If the net debt is less than 5 times the net income, then the company is very likely to easily overcome a recession.
The last feature I look for is a program of aggressive repurchases of the company's shares. In the case of a market correction, the temporary decline in the share price enables the company to purchase a higher percentage of its own shares so the percent of ownership is greatly enhanced for the remaining shareholders.
The companies listed below fulfill all the above features and, in my opinion, represent the best recession-proof stocks.
McDonald's is well known for its model of value for money and hence its business model is not vulnerable to a recession, as more consumers turn to this choice in rough times. To be sure, in the Great Recession of 2009, the earnings of McDonald's grew by 5% and were further enhanced by share repurchases, resulting in 10% growth of the earnings per share (NYSEARCA:EPS). The stock did not follow the performance of the company, as most investors were extremely pessimistic during the deep recession. However, it still greatly outperformed the market, as it declined only 20% (from top to bottom) while the market declined 55%.
The stock currently trades at a somewhat high P/E (17.5) but this is almost inevitable for this premium stock. The company distributes a 3.4% dividend and repurchases 2%-3% of its shares every year. Its net debt is less than 3 times its annual net income so the company can easily withstand any headwind.
Wal-Mart is another popular, non-cyclical company, as its model of value for money attracts more customers during a recession. To be sure, in the toughest of all years, 2009, its earnings increased by 6%. Although the stock did not follow the performance of the company in the gloomy days of 2009, it greatly outperformed the market, as it declined only 25%.
The stock currently trades at an attractive P/E (14), which is a surprise gift for an exceptional company that has increased its earnings for more than 20 consecutive years (still counting). The company pays a decent dividend of 2.5% and repurchases about 3% of its shares every year. Its net debt is somewhat high at around 6 times its earnings but should not be a concern for investors.
International Business Machines (NYSE:IBM)
IBM would normally be considered a cyclical company, as its business customers tend to curtail their budget during rough times. However, the business model of the company involves recurring income every year from its customers. This was reflected in the performance of the company in 2009, when its earnings increased 10%. Unlike the two previous companies, it is remarkable that this stock declined almost 50% during the Great Recession, thus completely ignoring the outstanding performance of the company. However, when this occurs, the investor should be patient because in the end the share price always follows the EPS of the stock. At the bottom of 2009, the stock traded just 7 times its earnings, which was a unique investment opportunity.
IBM has an exceptional growth record and currently trades at a bargain P/E of only 11. It is the third-largest investment of Warren Buffett, representing almost 15% of his portfolio. The original stake was purchased in Q3-2011 at $158-$185 and has been raised by 20% since then. The company distributes a 2% dividend and, even better, has announced a massive buyback program of $50 B for the next 5 years, which is sufficient to reduce the share count by 25% at the current price. Therefore, a unique opportunity exists in this stock at the moment.
L-3 Communications Holdings (NYSE:LLL)
L-3 provides systems and services in the defense sector of the country. Most of its revenue is currently derived from the Department of Defense, which is a two-edged sword; the budget for the defense sector is scheduled by Obama to be reduced in the next few years but, if Republicans prevail in the next election, the budget may increase again.
During the Great Recession, the company managed to maintain its EPS essentially constant. Again as in the case of IBM, the stock declined almost 50% during the Great Recession, thus completely ignoring the excellent performance of the company during that period. Nevertheless, a stock always catches up with its fundamentals when the pessimism is gone so this stock has been performing greatly. It is of great importance to be patient when the stock declines while the company maintains its excellent performance.
L-3 currently trades at a low P/E (11), distributes a 2.2% dividend yield and has announced a massive buyback program of $1.5 B till June-2015, which is sufficient to reduce its share count by 20% at the current share price. Therefore, in my opinion, the stock currently represents an attractive investment case.
Note: All financial data has been taken from finance.yahoo.com
Disclosure: I am long IBM, LLL, WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.