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Recessions and the Dividend Investor

Author: 
George L Smyth
13 mins
January 5th, 2023
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Although our country has not been through a crisis of this magnitude since the Great Depression, experience can give us an idea as to what to expect and help guide us through the COVID-19 Recession.

We are not officially in a recession but yes, we are in a recession. Those who have been investing only during the longest bull market in our nation's history are encountering new territory. It is no longer a case of casting one's money into the winds of stock investments and having confidence that it will land on fertile soil. We have entered turbulent times and there will be true losses, but there will also be true opportunities for those with a steady hand on the wheel.

I will look at what a recession is, and as was the case in the article Lessons Learned, will attempt to divine a direction based on experience and history. This is done in an atmosphere where many others are panicking, which is why you must have a calm head. While others panic, an idea as to what to expect can help guide the long-term dividend investor.

Recession

In the past, most economists described a recession as two successive quarters of negative growth. The National Bureau of Economic Research, which determines the dates for events such as this, has more recently defined it as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”.

Under either definition, one cannot definitively state that we are currently in a recession because it is something we will only know looking into the past. However, with COVID-19 affecting over one million people worldwide and the S&P 500 down significantly at the time of this writing, I think that it is safe to assume that we are in the midst of one.

Since World War II there have been 11 recessionary cycles lasting from six months to multiple years. Despite this, the long-term trend in the United States has been that of economic growth. The last expansion began in June 2009 and lasted over ten years, which is one reason I have been expecting a recession for quite some time, though I was certainly not prescient enough to have guessed its cause. Before that, the expansion stretched from March 1991 to March 2001, so the past 30 years have been amazing.

The Business Cycle

A recession is part of the business cycle, which is characterized by expansion and contraction. The bottom of a recession is called the trough, and can only be seen in hindsight, as the subsequent part of the cycle, the recovery, often comes in fits and starts. The expansion follows this until it hits its peak, at which point it contracts again into recession. Since World War II the average contraction has lasted 11 months while the average expansion has lasted 58 months, so normally we are experiencing the upside of the cycle.

This is the crux for the long-term dividend investor. It’s like a roulette wheel that has six slots, five winners and one loser. Some may see the losing slot and panic on its negativity, but like counting cards, playing the long-term allows the odds to move in one’s favor.

The 2008 Recession

Before getting started I will state the obvious, which is that the COVID-19 Recession will not be like the Great Recession. The cause and reaction to it are completely different, so comparisons between the two need to be tempered by this understanding. However, It behooves us to understand what survived the biggest financial threat in nearly one hundred years, and determine whether or not it is relevant to the current situation.

In 2008 the S&P 500 dropped 38.5%, suffering its worst percentage loss. The year was a disaster for most companies and many did not survive. However, some were untouched. Below is a table of the ten companies within the S&P 500 that performed best during that year.

Company

2008 Total Return

Industry

Dollar Tree Inc. - DLTR

60.8%

Discount Stores

Vertex Phamaceuticals Inc. - VRTX

30.8%

Biotechnology

H&R Block Inc. - HRB

25.8%

Personal Services

Amgen Inc. - AMGN

24.3%

Drug Manufacturers-General

Old Dominion Freight Lines Inc. - ODFL

23.2%

Trucking

Walmart Inc. - WMT

20.0%

Discount Stores

Edwards Lifesciences Corp. - EW

19.5%

Medical Devices

Ross Stores Inc. - ROST

17.6%

Apparel Retail

Alaska Air Group Inc. - ALK

17.0%

Airlines

Hasbro Inc. - HAS

16.8%

Leisure

The common thread through many of these companies is that they dealt with essential goods and services that needed to be maintained regardless of financial condition. With recessions come unemployment and a tightening of financial resources. Extravagances that accompany good times are put on the shelf for another day.

There are three general categories in this list and we should briefly identify each.

Discount Stores

Two of the top ten companies in 2008 offered goods to the consumer at discount prices. If an individual is hurting for cash then they are likely to make purchases in places that save them money. The narrow and packed aisles of Dollar Tree and the huge parking lots and stores of Walmart are no longer a deterrent.

Healthcare

In the S&P 500, only 34 companies were able to survive in 2008 without a loss in stock price. Of this group, 7 companies were involved in healthcare, three being in the top ten. Regardless of the economy, one's health is paramount and consumers are likely to maintain their spending to be healthy.

Freight and Logistics

Regardless of the economy, goods need to be moved from one place to another. While vacation may be put on hold, the movement of products to stores must continue. Of the 34 companies mentioned above, three were in this category.

Presence in a particular industry does not ensure success. Recessions affect companies negatively and they must be strong enough to survive, let alone prosper. Discount stores must not only maintain inventory to sell to customers but also need to increase their stockpiles to take advantage of potential additional sales. A strong balance sheet allows for this expansion, with a low debt-to-equity ratio providing the ability to pour cash into the situation.

The Dividend Advantage

Income from dividends during recessions is a comfort. As stock prices fall those who have the consistency of dividends are in good shape – as long as the dividends continue. Counting on abnormally high yield dividends can be a source of concern if these companies move profits to other areas.

This is why I have been pointing to Dividend Champions, which are companies that not only maintained but increased their dividends throughout the past two recessions. During the Great Recession of 2008 about one-third of the companies in the S&P 500 cut their dividends, so the current list of Dividend Champions contains survivors of that event, as well as the Dot-com bubble of 2000.

While dividends generally tend to fall during a recession, they are less volatile than stock prices, making them excellent investments. SimplySafeDividends shows the S&P 500’s price fluctuations to be more severe and frequent throughout the 1968-2018 timeframe. While stock prices move at the whims of short-term investors looking for temporary advantages, dividends are commitments given by companies to give back to their shareholders. There is an incentive to maintain the dividend once offered and this acts as a smoothing factor.

2008 Successes So Far

I felt that it might be interesting to chart how the companies that best survived 2008 are doing since 19 February 2020, the S&P 500’s high point.

2008 Winners this time around

Graph provided by Stock Rover

Walmart is acting as if nothing is happening. Since the market's high, they have not seen a decrease in price and have even slightly advanced. Vertex Pharmaceuticals and Amgen are showing a minimal decline, and Old Dominion Freight Lines, Edwards Lifesciences, and Dollar Tree are doing better than the index. These companies are in the three industries noted above, which is not a surprise. At the time of this writing, healthcare is the least hard-hit sector.

To highlight the difference of the causes between the Great Recession and the COVID-19 Recession, Alaska Air Group has lost nearly two-thirds of its value for obvious reasons. One would need to look into the company's financials to determine whether this is an opportunity or a company to avoid as much as the virus.

Lessons Looking to the Future

Recessions are a time for panic and profit, the latter group oftentimes coming as a result of the actions by the former group. There are things we know, things we do not know, and things that we can guess through experience. Informed decisions can help guide us in a direction that will be of lasting benefit when it is time to reap what we sow.

Amazingly there are still states within the United States that have not mandated stay-at-home orders, so infection curves will be layered, thus lengthening the time before a business will be able to return to normal. The government is throwing money at the problem which will be helpful in the short-term. This increase in debt will remain on the books as there is no history of an effort to reduce debt, so some of the effects of the recession will be permanent.

As we have not been through a problem of this magnitude since the Great Depression the unknowns could fill a book. The most pressing of these is how long the difficulties will last. It is almost certain that the United States will continue its infection rates long after most other countries have seen its end, thus the time to return to normal will be stunted.

In that respect, it may be prudent to look at companies with international exposure. If profits are concentrated within the United States and we have a long recovery, sales and services offered outside of the country may be a driving factor for profitability.

Discount stores, healthcare, and freight and logistics are essential components of any economy, and inelastic pricing helps maintain cash flows in times when spending cuts make this difficult. The ability of a company to maintain its dividend to investors should be examined by understanding the underlying risk of the company under consideration.

However, when examining companies one should not simply look at the ability to get through the recession but should also consider the possibility of long-term benefits. Once the period of expansion begins a great company will have the ability to absorb the remains of companies that have fallen by the wayside. Whether this recession lasts six months or five years (or longer), the best investments are those that can be held forever.

Finishing Up

As always, research is the name of the game. We know that discount stores should fare well during this recession, but that is not enough. From 2008 through 2012 Dollar General, Family Dollar and Dollar Tree became market favorites and added thousands of stores. Walmart did well and continues its dominance. One needs to open up the financials of these and other like companies to see if their cash flows will allow them to do so now.

Another group of companies that should do well during the recession is those that provide crucial services. Waste management is an example of a service that cannot be stopped, as would be the case with most utilities. Additionally, companies that supply consumers with the ability to maintain their cars and paint their houses would fill the gap for those who have previously paid to have these things done by others.

Essential consumer goods would be another area to consider. Toothpaste and shampoo will continue to be used by those who have decided to drink fewer lattes and eat out less often. Grocery stores will still need to supply food and other daily necessities we cannot live without.

Pharmaceutical and healthcare companies will continue to supply consumers with necessary drugs that maintain our health, and companies that inspect pipelines will still be required to prevent ruptures and damage. Some mandates require certain goods and services to continue to be available and companies that work in these areas should be one's shortlist of investment opportunities.

Just a note here – these are pretty much boring companies. They remind me of The Millionaire Next Door (a book I would recommend everyone should read). Sleek and sexy is all well and good, but there are gems to be found in what we consider to be pedestrian. Just because a company’s primary product is something we use and toss, that does not necessarily mean that we should similarly toss it from consideration. Sometimes boring can equal profitable.

The bottom line is that at least in the short term there are things that people and companies choose to purchase, and things that they have to purchase. During these times companies that deal with the necessities have the best chance of survival. The next step is to consider which of these companies will continue to thrive, and possibly as the result of this recession come to dominate their space. Finding them is a challenge for the long term investor.

A major difficulty is that all information at this time comes from before the virus hit the United States. April is a time when many companies begin to offer their quarterly reports and we will start to learn the effect of the crisis. When I look at a company’s intrinsic value, the numbers are based on what happened during a thriving economy. When reporting time comes we will have a window into how the downturn is affecting the companies of our choice and conference calls will give company officers a chance to tell investors the plans they have to survive the recession.

Of course many will want to dive right in and immediately invest in this environment, but the truth of the matter is that there should be plenty of time to make decisions. While I would be more than thrilled were this not the case, unfortunately, there is almost certainly more downside coming and a long recovery ahead. This will allow ample opportunity to find great companies that offer excellent returns and dividends well into the future.

Stay safe.

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Contributors

George has been investing in stocks since 1992 and founded DripInvesting.org, the foremost authority on dividend investing (acquired in 2022 by Moneyzine). He began his investing journey late, realising he was behind in saving money for retirement and seeing an oncoming threat of college expenses for his two children. What seemed destined for failure was soon followed by success upon realising the advantages of long-term dividend investing. Aside from DripInvesting.org, George has held a role as a weekly contributing author at The Motley Fool, writing numerous articles about dividend investing.
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