I expect a recession within the next one or two years although the stock market and the three major indices like the Dow Jones Industrial Average marked new all-time highs.
Healthcare, Pharmaceuticals and Consumer Staples will be among the sectors outperforming the Dow Jones Industrial Average or S&P 500 during the next recession.
Novo Nordisk, CVS Health and Altria Group are three good picks for an economic downturn and all three are also interesting for dividend investors.
CVS and Novo Nordisk will profit from a growing demand in healthcare and especially Novo Nordisk will profit from a higher diabetes prevalence resulting in the need for more insulin.
I know it still sounds ridiculous to talk about a potential recession, while the US stock market is rushing from all-time high to all-time high. And I also know that my staying to the sidelines for several months now – my last purchase was CVS Health (CVS) in April 2019 – made me miss out on potential gains as the three major US indices increased between 20% and 30% since the beginning of the year.
An increase of 30% within 11 months sounds impressive, but it always depends on the timeframe we use. When looking at the performance since October 2018 (instead of January 2019), the S&P 500 (SPY) gained only about 7% or when looking at the performance since January 2018, the S&P 500 gained about 9.4% within almost 2 years – which is not so impressive. To sum up the last two years, we can probably state that the US stock market could continue to crawl higher and depending on the time of purchase, one could achieve double-digit gains within a few months, but it might not have been the best time for long-term investments.
Although the stock market is still climbing to new record highs after the shock in the fourth quarter last year where the US stock market decreased almost 20%, the fundamental picture is not looking so great. The stock market might be able to gain additional 10% or even 20% (and the situation could be like in 1998), but in my opinion, the upside potential is very limited while the downside risk is extremely high. It clearly depends on the choice of indicators we are looking at, but several indicators are sending clear warning signs while others are still signaling strength. The labor market is still in a very healthy condition with unemployment rates being at record lows (lowest unemployment rate since the 1950s), the job growth still being solid and the initial unemployment claims stagnating at a low level. After showing some weakness, the housing market also looks strong again with the new housing permits being again at the highs of this economic expansion. The yield curve has normalized again and is now extremely flat on the left-hand side and a little steeper at the right-hand side.
(Source: Own work based on numbers from U.S. Department of Treasury)
But there is also a different point of view one could take and parts of the data could also be interpreted a little differently. Let’s start with the yield curve, which was inverted a few months ago (see chart above) and has normalized again for a very simple reason: the Fed has lowered the Federal Funds rate three times within a few months (75 basis points in total). And what the Fed is calling a mid-cycle adjustment is actually a rather bearish signal as the lowering of the Federal Funds rate is often preceding a recession. And the Fed lowering the Federal Funds rate is also influencing the yield curve on the left-hand side (short term rates) and leads to a normalizing yield curve. The once inverted yield curve normalizing again is another event occurring before every recession.
And not only the yield curve can be interpreted from a bearish standpoint. While the labor market is clearly in good shape, the number of added new jobs every month is slowing down (chart is showing percentage change YoY).
Finally, we can also look at the earnings of companies listed in the S&P 500. Between December 2018 and the end of the second quarter, earnings stagnated and for the third quarter (with almost all companies having reported quarterly results) earnings declined 2.3% according to FactSet (NYSE:FDS) (reflecting the companies already reported at the mid of November). For the fourth quarter, analysts are also expecting earnings to decline about 1.4%. During recessions, earnings often decline in the mid-double-digits and a small single-digit decline for several quarters is nothing to freak out, but one has to question if the major indices climbing from all-time high to all-time high with already extremely high valuations is justified.
(Source: Advisor Perspectives)
How To React
Knowing that the downturn risk is quite high, the question is how to prepare for these downturns. The most obvious way not to be affected by downturns is to sell stocks beforehand, but that might not be the smartest way for several reasons: the taxes one has to pay when selling a stock or timing, which is a much bigger problem. Selling exactly at the top seems like a really difficult task and the chance of missing out on double-digit gains (either by selling too early or by selling too late) is a big risk and while missing out on 15-20% gains is not a big problem for long-term investors, it makes quite a difference when investing with a time horizon of only several years.
A second way to protect a portfolio against downturns is to stop buying stocks. And while that strategy is more reasonable than selling all stocks, timing is also an issue as an investor has to decide at what point in time, he or she will stop buying stocks – and the risk of being too early or too late also comes into play.
The final solution might be continuing the purchase of stocks, but maybe invest smaller amounts into the stock market (compared to three or five years ago) and focusing especially on recession-resistant stocks as well as on sectors that performed well in past recessions.
When analyzing which sectors have outperformed the overall market during recessions and downturns, the list is not always in the same order, but a few sectors are usually taking the top spots. Utilities and energy stocks are leading the list in most cases, followed by consumer staples and healthcare stocks (with telecommunication stocks also showing up in this list). The products and services these companies offer are unlikely to see a decreasing demand – even in tough times – because people see them as basic needs.
(Source: Stansberry Research)
When trying to build a recession-proof portfolio, these should be the sectors we are focusing on and as I have not really focused on energy or utilities in the past, I don’t have much knowledge about these companies making it quite hard to pick stocks from this sector. Instead I picked three stocks from the healthcare sector (one pharmaceutical company and a healthcare service provider) and one company from the consumer staples sector.
Dividend Yield (FWD)
P/E GAAP TTM
Revenue Growth (10yr. average)
RoIC (10yr. average)
When looking at the performance of these three stocks during the last recession – I took the timeframe between January 2007 and December 2009 – those three stocks outperformed the S&P 500 the entire time and the decline was not as steep as the decline of the index.
And just to prevent misunderstandings: Recession-proof does not mean these stocks won’t decline. In case of a severe recession, all three stocks might also decline 30% or 40%, but probably won’t decline as steep as the major indexes (which could crash 50% or 60%) and these stocks might also recover faster. In the following sections, we will look at the three companies individually and focus on aspects like the performance during the last recession, describe the business and why it is rather recession-proof and end with a look at the dividend (as all three stocks are stable dividend payers) and the long-term growth potential.
Novo Nordisk (NVO)
Novo Nordisk is a Danish pharmaceutical company existing for almost 100 years and generating more than 80% of its revenue from diabetes and obesity products. The company is rather concentrated as revenue is stemming only from a few products (most of them have reached blockbuster status). Novo Nordisk is generating its revenue from different insulins (human insulin, long-acting insulin, fast-acting insulin) as well as GLP-1 products and products to treat obesity. When looking at these products and the underlying diseases (type 1 diabetes, type 2 diabetes and obesity) it is not like the patients have any choice – they need the products no matter what happens and an economic downturn is no reason to stop purchasing the products.
This high level of stability and consistency is also reflected in the numbers Novo Nordisk could report during the last recession. When looking at the timeframe between 2006 and 2010, Novo Nordisk could increase revenue every single year. An increasing revenue even during recessions is something several other companies also achieved. Novo Nordisk, however, could increase earnings per share and free cash flow every single year as well, which is really impressive and underlining what an outstanding company Novo Nordisk is.
(Source: Novo Nordisk Earnings Presentation)
Novo Nordisk is not only market leader in its two most important business segments – diabetes and obesity – but it is also combining high levels of innovation with a strong economic moat around its business. Additionally, Novo Nordisk will profit from an increasing demand for its products due to an increasing number of diabetics and obese people all over the world. Novo Nordisk seems fairly valued right now, which is also good in case of a potential recession. Extremely overvalued stocks tend to get punished much harder in case of a recession and the decline is rather steep when sentiment changes from extreme optimism to (extreme) pessimism.
Aside from being a great long-term investment, Novo Nordisk is also paying a semi-annual dividend. In 2018, the total annual dividend was DKK 8.15, which is resulting in a dividend yield of 2.12% right now. And although the payout ratio of 50% is rather high, Novo Nordisk could grow its dividend more than 20% every single year during the last decade.
CVS Health (CVS)
Not only pharmaceutical companies have a rather recession-proof business model. Healthcare service companies tend to be untroubled by huge earnings declines during recessions. CVS Health is an American healthcare company generating its revenue from different segments – pharmaceutical retail stores, pharmacy benefit management and healthcare benefits. In total, CVS is offering a wide range of healthcare products and services. CVS is generating revenue from selling pharmaceutical products through its 10,000 retail stores and after the acquisition of CVS Caremark, the company is also one of the big pharmacy benefit managers in the United States. In November 2018, CVS acquired Aetna, a healthcare insurance company and diversified its healthcare business even more. Aside from some exceptions (the front store products, for example, which make up about 6% of the company’s total revenue), most of CVS’ products and services are essential. Even during an economic downturn, customers need healthcare services, be checked out by a doctor or fill the prescriptions and buy medications from pharmacies.
When looking at the performance during the last recession – and especially at the years between 2006 and 2010 – CVS could increase its revenue every single year during the recession, but revenue decreased about 2.5% in 2010 compared to 2009. The picture of the company’s operating profit and earnings per share is pretty similar: between 2006 and 2009, operating profit and EPS increased every single year, but in 2010 earnings per share decreased about 2.7% compared to the previous year.
CVS Health is a market leader in the pharmacy retail business and also holds the top spot among the pharmacy benefit managers. While CVS might not have a similar wide moat as Novo Nordisk, the company is still well-positioned for a great performance in the future. The company is also trying to be innovative and differentiating itself from competitors – for example, by rolling out its HealthHUBs all over the country in the next few years.
And CVS might be a great investment as the stock is still undervalued. Investors were very pessimistic about the acquisition of Aetna as well as the resulting goodwill and debt levels and sent the stock down in the last few years. Due to a goodwill impairment charge, CVS had to report a loss in 2018 (GAAP numbers) and in 2019 and 2020 management is expecting growth to be only in the low single digits (non-GAAP numbers). But over the long run, CVS is confident it will return on the path of growth and is expecting double-digit EPS growth from 2022 going forward. And as CVS is still undervalued, the chances are high that CVS will not decline as much during a potential recession or at least recover rather quickly after a downturn.
(Source: CVS Investor Day Presentation)
Altria Group (MO)
The third and final company is Altria Group, which is a holding company and sells cigarettes, smokeless products and wines. It includes brands like Marlboro, Black & Mild, Copenhagen or premium wines like Chateau Ste. Michelle. Altria holds an equity investment in Anheuser-Busch InBev (BUD) and JUUL Labs, Inc. (JUUL) Altria is generating most of its revenue from smokable products (about $22.3 billion or 88.1% of revenue), while about $2.3 billion in revenue was generated from smokeless products and $691 million from wine (in 2018). Although one could argue if cigarettes and cigars are basic needs customers have, they sure as hell make addictive and this leads to a stable demand for these products (even during economic downturns).
Although Altria could not report numbers like CVS Health or Novo Nordisk, the performance during the last recession was also solid. Revenue declined 0.7% in 2007 compared to 2006, but in all the other years, revenue increased. We saw a similar picture for operating income – the number also decreased in 2007 while it could increase in all the other years. Earnings per share decreased about 4% in 2007 and were stable in 2008. All in all, the performance during the last recession was solid and underlines that Altria is also a recession-proof business.
Compared to CVS Health and Novo Nordisk, the long-term growth potential for Altria might be limited. In fact, Altria already has troubles to achieve growth as revenue is only growing in the very low single digits. The number of smokers is decreasing, which is good for the people and the society as a whole (lower healthcare costs), but it is a problem for companies like Altria Group. Over the last decades, the number of smokers in the United States declined – the number was around 50 million smokers for several decades, but since the 1980s the number declined over the years to about 35 million. But globally the number of smokers seems to be pretty stable (with the number of smokers increasing in Africa and the Eastern Mediterranean region).
While the long-term growth potential seems rather limited for Altria (especially compared to investments in CVS Health or Novo Nordisk), the company could be interesting for its dividend. Currently, Altria has a high dividend yield of 6.83% and it could increase its dividend every single year since 2009 (Altria had to cut its dividend three years in a row – from 2006 till 2009 – but in the years before, Altria could also increase the dividend annually since 1989).
In my opinion, all three companies could be a good investment for a potential recession as all three companies have not only a recession-proof business, but are also valued attractively right now. All three companies have also declined rather steeply in the last few years and seem to come out of the trough (in case of Altria, I would not be so sure if the stock already reached the bottom) and while Novo Nordisk and CVS are both good investments with long-term growth potential, Altria could be very interesting with its high dividend yield of 6.83% (despite an extremely high payout ratio). While I already own CVS Health and Novo Nordisk, I probably wouldn’t buy Altria for several reasons – mostly because I don’t want to invest in the tobacco industry and due to the difficulties to achieve growth (which will probably continue in the years to come).
And I personally would not invest high amounts of money into the stock market these days, but rather wait patiently for better buying opportunities. I will buy, if I find investments, that are convincing (like CVS Health a few months ago), but I will not invest in the stock market at all costs and I am perfectly fine with staying to the sidelines for now.
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Disclosure: I am/we are long CVS, NVO. 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.