Choosing stocks to get you through

With high inflation and risk of recession looming, now is a good time to ensure the stocks you own are resilient.

To do that, it makes sense to hold a diversified collection of stocks that are supported by strong investment fundamentals and can be expected to outlast adverse economic conditions.

Be prepared to stick with those stocks should the market suffer a big drop. And steer clear of speculative investments like meme stocks, unproven tech stocks and cryptocurrencies.

There are various specific approaches for putting those basic investment principles into practice. In what follows, I describe the approach used by Mawer Investment Management Ltd. in its Mawer Global Equity Fund, a top-quartile mutual fund that has outperformed its index over 10 years, according to Morningstar.ca.

Mawer understands that resilient stocks are based on resilient underlying businesses that can generally get through a bout of inflation or an economic downturn in reasonably good shape.

“We’re not trying to predict the future, but we’re trying to ensure these businesses are strong and enduring and going to last,” says Paul Moroz, Mawer’s chief investment officer.

Under Mawer’s version of investment fundamentals, they have long sought quality stocks without too much debt, that are proven wealth generators, with strong management, a competitive advantage, bought at an attractive valuation.

In the current environment, the firm is particularly cautious about unsustainable debt and wants businesses with pricing power that can pass on inflation, “although the core philosophy doesn’t change,” says Moroz.

Resilient stocks will likely still suffer short term to a degree should a recession materialize, but they should be well-positioned to recover and thrive long term.

Stocks to avoid include those that are particularly susceptible to adverse economic conditions or those that have been bid up by speculation. Speculative stocks often suffer particularly big reverses during market sell-offs.

The Mawer fund includes stable stocks with modest growth and relatively low price-earnings ratios, but it also has more volatile tech behemoths with strong long-term growth prospects and relatively high price-earnings ratios.

Common factors are quality and resilience. But including stocks from different sectors with different growth profiles helps provide diversification, Moroz says.

One of the fund’s largest holdings is Marsh & McLennan Companies Inc., a New York-based global insurance broker. Close to 90 per cent of its revenue is recurring due to the nature of insurance as a nondiscretionary expenditure, he says. It’s also a business that can pass on cost inflation to customers.

Another holding is Amsterdambased JDE Peet’s N.V., the world’s second-largest coffee company. He finds its valuation reasonable at about 16 times forward earnings and believes the company can still do well with inflation or a slowdown. One typical feature of recessions is that risks that may not be apparent during good economic times can suddenly have devastating impacts when economic conditions sour.

Consider the example of Cineworld Group plc, the world’s second-largest theatre chain, which filed for bankruptcy in early September. Mawer held the stock at one time but sold when Cineworld started loading up on debt to finance ambitious acquisitions. While the stock did reasonably well for a few years, the company was done in by its massive debt load and changing movie-viewing habits during the pandemic.

Moroz sees value in some of the big tech behemoths with strong, scalable, growing businesses. Fund holdings include Microsoft Corp. and Alphabet Inc. (owner of Google). The tricky part is distinguishing strong, resilient tech firms with attractive prices from other firms that are overvalued or vulnerable.

“You have to be careful not to get too scared or too greedy with these scalable-type businesses,” says Moroz. You can’t be afraid to pay up for higher growth where justified, he says.

“What you have to be careful with on the greedy side is getting caught too far out on valuation,” he says. “You also have to be careful that the idea behind the stock isn’t just an (unproven) concept.”

Average investors

For average investors who manage their own investments, it makes sense to ensure you’re confident in the resiliency of your stock portfolio in timely fashion.

While major stock indices are down substantially from recent peaks — for example, as of Friday, the U.S. S&P 500 Index has fallen more than 20 per cent from its early January high — stocks could potentially fall a lot further if a deep recession were to materialize.

Focus first on the big picture of getting your long-term asset allocation right between stocks and investment-grade bonds based on your objectives, risk tolerance and other factors.

When it comes to selecting stocks, find a long-term approach that is supported by fundamentals that you’re comfortable with and then you should largely stick with it.

Be cautious about making wholesale portfolio changes without thinking it through. It’s easy to overreact to short-term marketmoving events based on emotion.

“Just keep it very simple and minimize the number of times you will have to make a decision when the market is going through a big move,” advises Dan Hallett, vicepresident of research at HighView Financial Group. “Deploying a long-term portfolio and for the most part sitting on your hands is likely the most practical way for most people to have success with investments.”