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Stock Strategist

Recession Coming?

Economic crunch time has arrived. Block and tackle with these four picks.

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Several indicators suggest that a recession is likely getting under way. Even if we don't have a recession, weaker economic activity has certainly been weighing on a lot of companies, not to mention the minds and buying habits of investors.

But does that mean it's a bad time to buy stocks? Not necessarily. We've had nine recessions since 1950. If you had put $1 on the S&P 500 every month since 1950, your $695 would be worth roughly $11,192 today. But if you had the discipline, foresight, or luck to have broken up the $695 into nine equal chunks--buying the S&P 500 at the outset of those nine recessions--you would have about $13,750 today, or 22% more. Inflation would have taken a large chunk of that change, but putting your money to work in the market sure would have beaten stuffing it under a mattress.

Granted, past performance does not guarantee future success. In turn, it is also true that if you had waited for a few months after those recessions had started before buying into the S&P 500, you would have even done a little bit better. But buying stocks at the beginning of recessions can make sense. The S&P 500 is in the index of leading economic indicators for a good reason. Stock prices tend to go down before recessions begin, and appreciate before recoveries get under way. The signal is clearer on recoveries than on recessions, but that is part of the point.

In this article, I'll take a look at some of the most prominent recent recession indicators, and then offer some specific names that are looking cheap in this slowing economy.

Tracking the Economy: The Building Blocks
Gross domestic product (GDP) measures the total value of production in a given period. GDP includes consumption, investment, government spending, and net exports. It can be estimated with a spending approach or an income approach, which in theory should be roughly equal as one person's spending leads to income for others. In practice, the spending approach is emphasized because spending data is more timely. But both the spending and income methods attempt to get at the same thing--the real value of economic production.

The income-based approach to GDP helps illustrate how corporate earnings fit into the overall economy, and how trends in both can matter for investment choices. Concern about a corporate "earnings recession" has recently been spreading and intensifying. If you are rooted in P/E as a valuation metric relative to, say, anticipated growth rates or prevailing interest rates, we don't think you are necessarily wrong. But when entering an economic downturn, a focus on P/Es based on recent or near-term earnings forecasts can mislead, especially as analysts slash their earlier forecasts.

At Morningstar, we emphasize a longer-term approach, and our discounted cash-flow models extend out five to 15 years. We think the DCF approach helps us frame our thinking where it belongs--in longer-term trends. We know they are difficult to capture with precision, but they matter most for performance over time.

Our fair value estimates add two numbers: the present value of the discounted cash flow over a forecast horizon, and the present value of a long-term "perpetuity" at the end of the horizon. If one of our analysts builds slowing activity into sales and earnings expectations over the next year or two, that will play into the valuation. But so will longer-term cash flows, and the latter help root our valuations at times when P/E-based valuations are focused too closely on near-term doom.

We search for companies with "economic moats," which are firms that can produce durable economic returns through time. By "economic" returns, we are looking for firms that produce returns on capital in excess of the cost of capital. This does not necessarily mean we are looking for firms that are immune to recessions. Economic moats tend to insulate the best firms from the worst things that recession and inflation can throw at them. But some of the firms we like the best from a moat perspective are very sensitive to economic cycles.

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Bill Bergman has a position in the following securities mentioned above: HOG, HD. Find out about Morningstar’s editorial policies.