How to Invest During a Recession

Tips for successful investing in tough economic conditions

In economics, a recession is defined as a significant, widespread, and prolonged downturn in economic activity. A widely used rule of thumb is that two consecutive quarters of decline in the gross domestic product (GDP) constitute a recession.

During a recession, there is typically a downturn in consumer spending. As consumers start to spend less on discretionary goods and services business revenues and profits tend to come under pressure. This can have a negative impact on stock prices as future revenue and earnings expectations may start to fall. Investing during a recession can be challenging especially when it feels like all stocks, regardless of the industry are selling off. Here are some of my tips for successful investing in tough economic conditions:

Do not panic sell

It can be very unsettling to see the shares in your portfolio take a dip, however, if the fundamentals of the business have not changed then there is no reason to sell a share simply because of recessionary fears. It is important to ask yourself why you bought a particular share and what your investment thesis was. If this thesis has not changed then there is no reason to sell a share simply because the price has dropped.

Focus on companies with a strong balance sheet

During a recession, a companys profitability may come under pressure. A company will still need to meet debt obligations and interest obligations during this period, and this may prove to be difficult with declining profits and free cash flow. This is why it is important to invest in companies with a strong balance sheet and sufficient cash on hand to weather difficult economic conditions. When looking for companies with a strong balance sheet the following financial ratios should be considered:

Debt to equity ratio (debt/share shareholders equity)

Current Ratio (current assets / current liabilities)

Interest Coverage Ratio (net income / interest expense)

Cash ratio (cash and cash equivalents / current liabilities)

Look for opportunities

A recession can create an opportunity to build wealth and accumulate mispriced assets. During a market selloff, quality shares may drop in price and fall below their intrinsic value due to irrational market behavior. This can present an opportunity for a rational investor to accumulate assets that have been mispriced in times of a market sell-off. It is however important to focus on quality. A share that has dropped 50% from all-time highs is not necessarily cheap or undervalued. It is important to consider the price of a share in relation to the value of the company as price alone is meaningless.