Editors' pick: Originally published Jan. 7.
George Soros has a net worth of $23 billion. His hedge fund averaged returns of 20% a year for decades. In short, Soros knows about financial markets.
That's why many investors are taking his recent warning so seriously. Here's what Soros has to say about financial markets today:
"When I look at the financial markets there is a serious challenge which reminds me of the crisis we had in 2008."
Global financial markets are primed to suffer another crisis. Oil prices are plummeting, Europe, the United States, and Japan have tremendous government debt burdens, and China is struggling.
To be a successful investor, you have to know what you can and can't control. You can't control when markets rise and fall. You can control your thinking and what you invest in.
With the global economy threatening another recession, there are three critical things you need to do to prepare.
1. Invest In Great "Recession-Proof" Businesses
Recessions can permanently destroy your wealth only if you invest in businesses that go bankrupt during the recession.
By investing in high quality businesses that tend to do well in all market environments, investors can minimize the fear that is associated with falling stock prices during bear markets.
This does not mean that great businesses do not see their stock prices decline during recessions. In general (and there are exceptions), even great businesses go on sale during market collapses.
Long-term investors should look at the underlying business rather than the stock price. Take Wal-Mart (WMT) as an example.
The company's earnings-per-share each year through the Great Recession are shown below:
- 2007 earnings-per-share of $3.16
- 2008 earnings-per-share of $3.42
- 2009 earnings-per-share of $3.66
For comparison, take a look at the earnings-per-share of the S&P 500 over the same time period:
- 2007 earnings-per-share of $75.20
- 2008 earnings-per-share of $16.89
- 2009 earnings-per-share of $56.33
Wal-Mart's business performed exceptionally well during the Great Recession, increasing earnings-per-share while the market was collapsing.
Thanks to its excellent business performance, Wal-Mart's maximum drawdown (worst price decline) was 26%, versus 55% for the S&P 500.
Wal-Mart did so well during the recession because it has a reputation for selling low-priced consumer products people need regardless of the overall economy. When times get tough, people look to save by shopping at discount retailers -- and Wal-Mart is the industry leader (by a wide margin) in discount retail.
Wal-Mart is also a Dividend Aristocrat. To be a Dividend Aristocrat, a stock must have increased its dividend payments for more than 25 consecutive years. A company cannot accomplish this feat without having a strong and durable competitive advantage. This makes the Dividend Aristocrats Index an excellent place to look for great "recession-proof" businesses for your portfolio. Click here to see the 10 most recession proof Dividend Aristocrats.WMT data by YCharts
Aside from Wal-Mart, there are a few other great businesses that are currently trading at fair or better prices investors should consider adding to their portfolio to minimize recession fears. These are businesses that are likely to continue growing (or at least not shrink very much) during a severe recession.
General Mills (GIS) is one such stock. The company sells branded "dine in" foods under the following brands (among others): Annie's, Betty Crocker, Cascadian Farms, Cheerios, Fiber One, Trix, Immacualte, Nature's Valley, Progresso, and Yoplait.
When recessions hit, people tend to dine out less. This will likely translate into rising earnings and sales for General Mills. The company is currently trading for an adjusted price-to-earnings ratio of 18.4 -- which is likely around fair value for this high quality business.GIS data by YCharts
Another recession resistant stock trading at a reasonable price-to-earnings ratio is Verizon (VZ) . Verizon's wireless plans are essentials in today's world. How many people over the age of 13 don't have a smart phone in 2016? As a result, Verizon will very likely be able to at least maintain its earnings power through even a protracted recession. The company is currently offering investors a 5.0% dividend yield and is trading for a price-to-earnings ratio of under 12.VZ data by YCharts
2. Prepare Yourself To Not Panic Sell
The long-term trend of the market as a whole is up. The stock market has historically compounded shareholder wealth at 9.6% a year over the long run. Those gains only come to people who can hold through ups and downs in the market.
"You get recessions. You have stock market declines. If you don't understand that's going to happen then you're not ready, you won't do well in the markets"
- Peter Lynch
Individual investors typically get crushed during bear markets. When you see your stock prices fall, you may think you need to get out now to avoid further losses. This is not the case.
Source: Google Finance with author additions
When you panic sell, you will very likely miss out on the next great bull market. Selling when things are at their perceived worst is one of the most financially destructive decisions you can make. Imagine how difficult it has been for investors who sold all their holdings in early 2009 and waited to get back into the market until 2011 or 2012 -- well after large bull market gains had already been made.
The stock market in general -- and shareholder-friendly businesses with strong competitive advantages in particular -- has compounded buy and hold investors wealth exponentially over long periods of time. There's no need to game the system by trying to avoid bear markets and only participate in bull markets.
Have you heard the idiom "buy low sell high"? Panic selling based on fear and falling stock prices makes investors do the exact opposite -- sell low and buy back into the market when it has risen. Fear will destroy your long-term investing returns.
3. Use Falling Prices to Your Advantage
There's a part of me that gets excited about stock market declines. That's because market declines create fantastic opportunities not seen in bull markets. You get the opportunity to buy high quality businesses at going out of business prices during recessions.
"Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it"
- Warren Buffett
Buying during recessions (and holding for very long periods of time) is one of the primary methods Warren Buffett used to become so wealthy.
Most investors think about selling when prices fall. Do the opposite. Find ways to buy more stocks during recessions. If you've invested in high quality dividend growth stocks during normal market times, you will have a stream of dividend income you can use to reinvest in high quality businesses that have gone on sale.
For those who dollar cost average, recessions present the perfect opportunity to reduce your average entry price on holdings that are falling in value. Price is what you pay, value is what you get. Paying less for great businesses -- which is easy to do when everyone else is panicking -- is a great way to increase the value you are receiving for your investment dollars.
For everyone who sells, there's someone on the other side of the transaction who is buying. The people on the buying side during recessions are the Warren Buffett's and Seth Klarman's of the investing world. Which side of the trade do you want to be on?
"Be fearful when others are greedy and greedy when others are fearful"
- Warren Buffett