Some Ideas For A Recession-Proof Portfolio

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Includes: AAPL, DVA, ESRX, LBTYA, LBTYK, PTGX
by: Early Retiree
Summary

Recession signals are popping up everywhere.

But the data is never telling us what to do today.

Here are some ideas on what to do now to steer your portfolio through the next recession and potentially even profit from it.

There is always a recession coming

During the Q4/18 sell-off, quite a few "guru" investors (e.g. David Tepper) evidently anticipated a longer and deeper downturn and therefore sold more stocks than just some redemptions might have required. In January, these fund managers were certainly caught by surprise when the markets rallied quickly close to their recent highs.

One notable exception was Seth Klarman, who wrote in his annual letter that,

"The recent selloff likely presented a buying opportunity – you can go years without seeing such valuations – but not across the board and not one for the faint of heart."

Who ultimately will have been right is still not certain.

As we have seen on Friday, recession signs are popping up: A flattening yield curve is a quite reliable signal - but it really doesn't tell you what to do today, as - on average - markets still go up substantially after this signal before they turn south. Effectively, there have been several other signals over the past year or so, and late last year, unemployment data flashed alarm, too:

It is easy to see that unemployment can't go down forever and necessarily goes up a bit before a recession hits, as growth and investment slow. Effectively, high employment rates to some extent throttle the economy, as workers are harder to find and therefore become more expensive, which puts pressure on profit margins. So, it is another reliable forward indicator. But does it tell you what to do now? After all, the market is still up substantially from the December unemployment trend inversion (if it really will have been a trend inversion and doesn't come back down again).

And, markets generally go up over time. 36 months after yield curve inversions markets are on average up 2%. 18 months after the signal the plus is much larger at 15.70%.

So, the data doesn't really tell us much more than what we already know: There is always a recession coming. It doesn't tell you what to do. Some pros are reducing exposure, some see bargains, some simply don't care about macro.

The result is a probabilistic exercise, where market prices overall reflect the growing risk of an upcoming recession. On the other hand, this might mean that there is not much to lose once the recession materializes.

As markets price in a near-term recession risk, what's the real risk?

As FPA Funds recently warned, "risk is where you're not looking". For example, corporate debt:

The Fed's dovish U-turn on interest rates has probably somewhat reduced this risk.

Markets are dynamic and self-adjust to changing circumstances. If you own a diversified portfolio of stocks, you own small pieces of businesses that are already now adapting to an ever-changing environment.

Before winter hits, farmers bring their cattle back into the barn. If you own a piece of their farm, you don't need to sell the farm in autumn.

Some ideas on what to do now

In my subscriber service Stability & Opportunity, we are always looking out for compelling long- and short-term investment ideas. You know some of them: In one of my recent public articles, I made the case for an investment in Liberty Global (LBTYA) (LBTYK). A few weeks ago, I wrote about DaVita (DVA). During the December sell-off, I presented the small biotech concern Protagonist (PTGX) as my best biotech idea for 2019. (It has almost doubled since then and has certainly become more risky now.) As my readers know, I also bought Apple (AAPL) right around the lows in January.

With the exception of my textbook contrarian call on Apple, these ideas are united by a common thread: They do not depend that much on general market conditions, but almost only on company-specific developments.

Both Liberty and DaVita are waiting for regulatory approval of large corporate transactions. With positive news, they will get huge cash loads which will make their stocks extremely cheap. Under bad general market conditions, these companies will be able to repurchase huge amounts of shares at bargain prices. Otherwise, they will inevitably go up.

As generally all biotechs, Protagonist depends on a few important events and, in the near term, mostly on the continuation of a valuable partnership.

Another example would be my call on Express Scripts (ESRX) one year ago. We bought and sold this stock three times in Stability & Opportunity, making nice profits with little fundamental risk each time.

Nobody could explain the theory behind these investments better than one legendary investor that has inspired a lot of my work. Effectively, Seth Klarman's Baupost recently bought into my long-term favorite Liberty Global and almost tripled its position in Q4. And, this is despite Liberty being actually a pretty highly leveraged business. The following snippet from Baupost's Q4 letter actually indirectly explains the rationale for this investment:

"We believe another key element in portfolio management is curtailing the duration (the weighted average life) of one’s portfolio through exposure to investments with catalysts for the realization of underlying value. Catalytic events shift the outcome of investments from a reliance on future market multiples and macroeconomic developments (which are not at all under your control) to a dependence on your assessment of the outcomes, probabilities, and implications of announced or anticipated corporate events, including mergers and acquisitions, bond maturities, debt restructurings, bankruptcies, major corporate asset sales, spinoffs, and tender offers. No strategy can avoid all risk of loss. But we believe our approach should increase the likelihood of achieving sustainable gains with limited downside risk over the long- run. To put it differently, a portfolio of near infinite duration (such as an all equity portfolio without catalysts) can trade just about anywhere. With such exposures, if stock prices plummet, the odds go up that an investor will feel pressure to do the wrong thing and sell into market weakness. A limited duration portfolio, both because of the hopefully truncated downside in a bad market as well as the beneficial cash inflows (buying power) that catalysts usually generate, is hugely advantageous in navigating through turmoil."

As the end of this bull market approaches with total inevitability, I have positioned my portfolio following a similar strategy: We have focused on corporate events with DaVita, Liberty and previously with Express Scripts. All our biotech investments ultimately fall in this category as well, as their valuation depends on a few important events (mostly trials) and not on market multiples. These investments could possibly generate extremely valuable cash even during a market sell-off.

As far as the other half of the portfolio is concerned - which is of longer duration, but also of greater geographic and economic diversity - I have tried to focus on those companies which I perceive as being not at risk of "intensely short-term orientation, extreme loss resistance, and an inability to stand apart from a panicky crowd", as during a recession, I would like to own businesses that can actually profit from it. One example would be Apple which could put its large cash hoard to work, either by repurchasing its own shares on the cheap or by profiting from lower valuations for M&A. So, this part of the portfolio is broadly diversified across industries and geographies and looks for smart capital allocators with robust balance sheets. While their stocks will almost certainly suffer during a market slump, any sustained undervaluation would probably generate robust value for shareholders.

Disclosure: I am/we are long LBTYK, DVA, AAPL. 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.